Do Tax Cuts Encourage Rent-Seeking by Top Corporate Executives? Theory and Evidence

Abstract

This paper seeks to understand the role of tax policy in executive rent-seeking within the firm and income. While a longstanding literature maintains that executives are afforded discretion in obtaining rents, that the degree of exercising this discretion is influenced by tax policy is, however, not considered in the analysis of tax policy. We propose a simple model of executive pay, where executive effort (all value-creating activities) and rent-seeking (all value-diverting activities) are determined endogenously. The model shows that, under some conditions, rent-seeking, as well as effort, responds to changes in marginal tax rates. Moreover, (1) a positive association between the elasticity of taxable income with respect to the tax policy and the degree in which the internal institutions of the firm favor executives vis-à-vis shareholders, and (2) a negative association between the elasticity of taxable income and the executive's equity-at-stake, are manifestations of tax policy influencing rent-seeking. We empirically test these implications and find results that are consistent with the predictions of the model.