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

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 selfinterested 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.

Is adoption of restricted stock grants related with firm performance?

“…This study's empirical results are not consistent with those of many foreign studies, including Bryan et al (2000), Lambert and Larcker (2004), Oyer and Schaefer (2005), Brown and Lee (2007), Carter et al (2007), Lambert (2007), Aboody and Kasznik (2008), and Irving et al (2011). However, the results are consistent with the findings of Hall and Murphy (2002) and Blouin and Carter (2010).…”

“…stock grants (RES), which is in contrast to my previous findings and supports Hypothesis 2b. These empirical results are also consistent with those of foreign literature, including Lambert (2007), Aboody and Kasznik (2008), and Irving et al (2011).…”

“…Furthermore, the study of Bryan et al (2000) found that the incentive effect of restricted stock grants is smaller compared with that of employee stock options because of the linear characteristics of its compensation. Aboody and Kasznik (2008) also assert that because restricted stock grants allow employees to obtain the dividend distribution right before meeting the requirements, managers will raise the dividend rates due to selfish motives. Furthermore, regarding the employee retention effect of share-based compensation schemes, Oyer and Schaefer (2005) believe that the employee retention effect of employee stock options on key personnel is better than that of restricted stock grants because more efforts will be made to improve the company's future performance if key personnel can increase the difference between the option price and the disposal price in order to substantially increase the value of the share-based compensation scheme.…”

Taxes, earnings payout, and payout channel choice

“…Share repurchases are used for occasional payout of excess cash and is hence a more flexible payout device than dividends, which are more 'sticky' -especially with regard to downward adjustments (Ofer and Thakor, 1987;Stephens and Weisbach, 1998;Jagannathan et al, 2000;Renneboog and Trojanowski, 2011). CEOs with option packages tend to prefer share repurchases and avoid dividends because of the associated negative effect on their personal wealth in case part of their remuneration package consists of non-dividend corrected stock options (and restricted stock) (Fenn and Liang, 2001;Liljeblom and Pasternack, 2006;Aboody and Kasznik, 2008;Geiler and Renneboog, 2014). Companies can adjust their dividends to signal their prospects to the market (Bhattacharya, 1979;Miller and Rock, 1985;Allen et al, 2000;Allen and Michaely, 2003b).…”

Taxes, Earnings Payout, and Payout Channel Choice

“…Share repurchases are used for occasional payout of excess cash and is hence a more flexible payout device than dividends, which are more 'sticky' -especially with regard to downward adjustments (Ofer and Thakor, 1987, Stephens and Weisbach, 1989, Jagannathan, Stephens and Weisbach, 2000, Amihud and Li, 2006. CEOs with option packages tend to prefer share repurchases and avoid dividends because of the associated negative effect on their personal wealth in case part of their remuneration package consists of non-dividend corrected stock options (and restricted stock) (Fenn and Liang, 2001, Liljeblom and Pasternack, 2006, Aboody and Kasznik, 2008, Geiler and Renneboog, 2014. Companies can adjust their dividends to signal their prospects to the market (Bhattacharya, 1979, Miller and Rock, 1985, Allen, Bernardo and Welch, 2000, Allen and Michaely, 2002.…”