Review of Accounting Studies

, Volume 13, Issue 2–3, pp 216–251 | Cite as

Executive stock-based compensation and firms’ cash payout: the role of shareholders’ tax-related payout preferences

Article

Abstract

We hypothesize that the structure of executive stock-based compensation helps to align managers’ payout choices with shareholders’ tax-related payout preferences. Specifically, stock options, which are not dividend-protected, can deter self-interested executives from using dividends as a form of payout. In contrast, restricted stock, which is dividend-protected, is more likely to induce the use of dividends. Relatedly, shareholders’ preferences for dividends, which are taxed as ordinary income, can depend on the income tax consequences of dividends relative to those of long-term capital gains. To test our hypothesis, we investigate whether the exogenous changes in shareholders’ tax-related payout preferences following the 2003 dividend tax rate reduction result in predictable shifts in executive stock-based compensation and in managers’ payout choices. Consistent with our prediction, we find a positive relation between the increased use of dividends in firms’ payouts and the increased (decreased) use of restricted stock (stock options) in executive compensation, particularly for firms with a greater percentage ownership by individual investors and with lower costs associated with modifying the structure of their compensation plans. Our investigation of the role of shareholders’ tax-related payout preferences in the design of executive stock-based compensation extends the prior literature that has largely focused on the role of incentive contracts in inducing managerial effort, risk taking, and retention.

Keywords

Executive compensation Stock options Payout policy Dividend taxes 

JEL Classifications

G35  H24 J33 K34 M52 

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Copyright information

© Springer Science+Business Media, LLC 2008

Authors and Affiliations

  1. 1.Anderson Graduate School of ManagementUniversity of California at Los AngelesLos AngelesUSA
  2. 2.Graduate School of BusinessStanford UniversityStanfordUSA

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