Taxation and sorting of CEOs across firms

This paper investigates how the progressivity of the tax system impacts the allocation of CEOs across firms, and argues that understanding this impact is crucial for evaluating tax reforms. I demonstrate that when the tax system is progressive, high-skilled CEOs may end up working for relatively small firms, even if the CEO skill and the firm size are complementary. The driving force is the complementarity between the CEO effort, the firm size and the CEO skill: CEOs hired by larger firms optimally exert higher effort and, to obtain a given level of utility, must be rewarded with higher compensation. As a result, under progressive tax system, the CEOS in larger firms face higher marginal tax rates. This effect is bigger for more skillful CEOs, implying that, in equilibrium, highly skilled CEOs may be hired by less productive firms. I formalize this intuition in a two-sided matching model, and quantitatively investigate the importance of this mechanism. I find that, due to the progressivity of the U.S. income tax schedule, the equilibrium sorting of CEOs across firms may indeed reverse from positive to negative, and that accounting for endogeneity of the allocation of CEOs across firms is important for evaluating tax reforms.