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The Association Between Book-Tax Differences and CEO Compensation

In: HANDBOOK OF FINANCIAL ECONOMETRICS, MATHEMATICS, STATISTICS, AND MACHINE LEARNING

Author

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  • Kin-Wai Lee
  • Gillian Hian-Heng Yeo

Abstract

We examine the effect of book-tax differences on CEO compensation. We posit that CEOs can opportunistically exercise the discretion in GAAP to increase accounting income without affecting taxable income and in so doing increase their compensation. We test the data to determine which competing hypothesis dominates — efficiency or rent-seeking. Under the efficiency hypothesis, the board of directors uses the information in book-tax differences to undo CEOs’ attempts to artificially inflate accounting income and hence CEO compensation is negatively associated with book-tax differences. Under the rent-seeking hypothesis, CEOs gain effective control of the pay-setting process so that they set their own pay with little oversight from shareholders and directors. Directors do not use the information in book-tax differences to undo CEOs’ attempted earnings manipulation and this gives rise to a positive association between CEO compensation and book-tax differences. Consistent with the efficiency hypothesis, we find that CEO compensation is negatively associated with book-tax differences suggesting that directors use the information in book-tax differences to reduce excessive CEO compensation. We also find that strong corporate governance structure strengthens the negative association between CEO compensation and book-tax differences. Specifically, firms with high insider equity ownership and high proportion of independent directors on the board have lower CEO compensation when book-tax differences are large.

Suggested Citation

  • Kin-Wai Lee & Gillian Hian-Heng Yeo, 2020. "The Association Between Book-Tax Differences and CEO Compensation," World Scientific Book Chapters, in: Cheng Few Lee & John C Lee (ed.), HANDBOOK OF FINANCIAL ECONOMETRICS, MATHEMATICS, STATISTICS, AND MACHINE LEARNING, chapter 32, pages 1245-1269, World Scientific Publishing Co. Pte. Ltd..
    • Handle: RePEc:wsi:wschap:9789811202391_0032
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    More about this item

    Keywords

    Financial Econometrics; Financial Mathematics; Financial Statistics; Financial Technology; Machine Learning; Covariance Regression; Cluster Effect; Option Bound; Dynamic Capital Budgeting; Big Data;
    All these keywords.

    JEL classification:

    • C01 - Mathematical and Quantitative Methods - - General - - - Econometrics
    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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