CEOs’ capital gains tax liabilities and accounting conservatism

Abstract

Recent studies show that the tax-induced lock-in effect discourages CEOs from unwinding their unrestricted equity and subsequently exacerbates their risk-aversion. I investigate how CEOs’ unrealized capital gains tax liabilities (tax burdens) influence financial reporting conservatism. I find that the demand for accounting conservatism decreases with CEO tax burdens. Further analyses show that the negative relation between CEO tax burden and conservatism is stronger when the firm has high leverage and high default risk and when the CEO's incentives are more aligned with equity holders. This highlights the shareholder–creditor agency conflicts mitigation role of CEO tax burdens in reducing creditors’ demand for conservatism. I exploit the Federal Taxpayer Reform Act of 1997 and staggered state-level tax cuts that significantly decreased personal capital gains tax rates as identification strategies.