Taxing mobile and overconfident top earners

International Tax and Public Finance https://doi.org/10.1007/s10797-022-09730-4 Taxing mobile and overconfident top earners Andreas Haufler1 · Yukihiro Nishimura2 Accepted: 15 February 2022 © The Author(s) 2022 Abstract We set up a simple model of tax competition for mobile, highly-skilled and overconfident managers. Firms endogenously choose the compensation scheme for managers, which consists of a fixed wage and a bonus payment in the high state. Managers are overconfident about the probability of the high state and hence of receiving the bonus, whereas firms and governments are not. When governments maximize tax revenues, we show that overconfidence unambiguously reduces the bonus tax rate that governments set in the non-cooperative tax equilibrium, while increasing tax revenues. When the government objective incorporates the welfare of resident managers, however, bonus taxes also serve a corrective role and may rise in equilibrium when overconfidence is increased. Keywords Overconfidence · Bonus taxes · Tax competition · Migration Mathematics Subject Classification H20 · H87 · G28 We are grateful to the editor, Ron Davies, and three referees for their constructive and detailed comments. This paper was presented at the 5th Belgian–Japanese Public Finance Workshop in Louvain-la-Neuve and at the 2020 online conference of the IIPF. We thank David Agrawal, Traviss Cassidy, Daniel Gietl, Bernhard Kassner, Mohammed Mardan and Pierre Pestieau for helpful comments and Susanna Hassinen for excellent research assistance. For financial support we thank the German Research Foundation through CRC TRR 190 (Haufler) and MEXT/JSPS KAKENHI JP18H00866 (Nishimura). The paper was started when Yukihiro Nishimura visited the University of Munich. He wishes to thank the members of CES for their hospitality. * Andreas Haufler Yukihiro Nishimura 1 Seminar for Economic Policy, University of Munich and CESifo, Akademiestr. 1/II, 80799 Munich, Germany 2 Graduate School of Economics, Osaka University and CESifo, 1‑7 Machikaneyamacho, Toyonaka‑shi, Osaka, Japan 13 Vol.:(0123456789) A. Haufler, Y. Nishimura 1 Introduction During the last decades, top income earners have been able to increase their share in total national income in most countries.1 An important contributor to this increased income concentration is the prevalence of bonus payments and other forms of incentive pay. For example, Bell and Van Reenen (2014) show that the top percentile of income earners in the United Kingdom received 35% of their total pay as bonus income in 2008, and the bonus share was even 44% in the financial sector. Similarly, Lemieux et al. (2009) find for the United States that performance pay accounts for most of the increase in wage inequality above the 80th percentile during the period 1976–1998.2 At the same time, top income tax rates have been reduced in many countries. Egger et al. (2019) have shown for the OECD countries that income tax systems have become less progressive since the mid-1990s. They explain this development with the increasing international mobility of high income earners. Moreover, several countries specifically try to attract international top earners by means of tax cuts that are only available to foreign residents (Kleven et al., 2020). There is a substantial literature indicating that the international mobility of top managers has grown substantially over the past two decades (e.g. Staples, 2007; Greve et al., 2015).3 Theoretical work has shown that the international mobility of top income earners reduces the optimal progressivity of income tax schedules in the countries competing for the high-skilled, mobile population (Simula & Trannoy, 2010; Lehmann et al., 2014). These effects are confirmed in empirical studies demonstrating that foreign residents respond to tax incentives with an elasticity that is far larger than the response of domestic residents (Kleven et al., 2013, 2014; Akcigit et al., 2016). In this paper we introduce overconfidence as a behavioral trait of mobile top earners and ask how this affects the tax competition for them. Specifically we focus on overestimation as the most common form of overconfidence.4 The psychology literature has shown that many individuals overestimate their own abilities and talents, as well as the probabilities of advantageous events (Taylor and Brown 1988). This behavioral pattern is particularly pronounced among high-income individuals, who have experienced success in their previous career and attribute this success largely, or even exclusively, to their own abilities (Gervais & Odean, 2001). Empirical research has convincingly shown that company CEOs and top managers exhibit 1 See Atkinson et al. (2011) for an international comparison and Piketty et al. (2018) for a detailed study of income distribution in the United States, based on national accounts data. 2 More generally, Bryson et al. (2012, Figs. 1 and 2) show that the share of private sector employees with an incentive pay contract has risen substantially over time in most OECD countries, and is highest in the Scandinavian countries (around 30%) and in the U.S. (over 40%). 3 Staples (2007) investigates 70 of the world’s largest transnational corporations and finds that the percentage of firms with at least one non-national board member rose from 36% in 1993 to 75% in 2005. Greve et al. (2015) show that the internationalization of management boards is positively associated with the globalization strategies of firms. 4 Moore and Healy (2008) distinguish three notions of overconfidence: overestimation, overplacement (relating to comparisons with others) and overprecision. While overprecision relates to the margin of error in stochastic decisions, overestimation relates to the probability with which (typically positive) outcomes occur. 13 Taxing mobile and overconfident top earners systematic and persistent patterns of overconfident behavior.5 Thus Malmendier and Tate (2005) show that overconfident CEOs make excessive investments when their liquidity is high, and Malmendier and Tate (2008) show that overconfident CEOs engage in value-destroying mergers. Ho et al. (2016) demonstrate that banks with overconfident CEOs weakened lending standards prior to the 2007-2009 financial crisis, and performed worse in the crisis. Finally, Humphery-Jenner et al. (2016) show empirically that firms ‘exploit’ this overconfidence by adjusting their compensation structure and increasing the share of incentive pay. There are some well-known examples of top income earners that are both internationally mobile and overconfident. Perhaps the most obvious case is Elon Musk, a South African native who migrated to the United States. As the current CEO of Tesla, a large share of his wealth is invested in Tesla stock, a clear signal of overconfident beliefs in his firm (cf. footnote 5). Another example is Josef Ackermann, a Swiss national who chaired the Deutsche Bank from 2002 to 2012 and in 200 (...truncated)