Profits from insider trading are a means for executives at publicly held U.S. companies to offset changes in income taxes at the cost of minority shareholders, according to a new research paper by experts at Wharton and the North Carolina State University. For every dollar of higher federal or state taxes, insider trading helps executives to offset between 12 and 16 cents on their net compensation, according to the paper, titled “Executive Compensation, Individual-Level Tax Rates, and Insider Trading Profits.”
Executives typically have access to price-sensitive, non-public information that impacts the fortunes of their companies, but is not available to minority shareholders. “CEOs or other senior executives with private information that the stock price of their company is about to decline may sell their stock to [unsuspecting] minority shareholders, hurting them in the process,” said Wharton visiting accounting professor Naim Bugra Ozel, a co-author of the paper, who is also an accounting professor at the University of Texas at Dallas. “What our study shows is the tip of the iceberg.” Ozel’s co-author is North Carolina State University accounting professor Nathan Goldman.
Ozel and Goldman compared “abnormal profitability” of insider sales transactions around two federal and 12 state-level income tax rate changes between 2003 and 2016. The comparison between the two federal acts is telling because one lowered individual income taxes and the other increased them.
The two federal acts are the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), which reduced the overall tax burden on individuals, and the American Taxpayer Relief Act of 2012 (ATRA), which reversed the tax reductions of JGTRRA. The dozen states covered are those that increased income taxes by 2% or more in each instance, and include California, Hawaii, New York and New Jersey.
With the first act, the U.S. Congress aimed to “primarily reduce the near-term risks due to the economic slowdown following the 2001 recession,” the paper stated. The latter act was to avoid fiscal austerity measures and stabilize the federal debt, the researchers noted. The study covered 1,506 unique firms after JGTRRA and 1,575 firms after ATRA. The state-level tax changes covered 794 firms.
‘Abnormal’ Insider Trading
According to Ozel, their study reconciles findings by earlier studies that executive compensation does not respond to any tax changes. By looking at executive compensation at a broader level that includes insider transactions, Ozel and Goldman establish that the two are indeed linked.
“What our study shows is the tip of the iceberg.” –Naim Bugra Ozel
They found that following the enactment of JGTRRA, “abnormal insider trading profitability significantly declined” in the six months starting three months after the enactment, but increased after ATRA came into effect. (The study covers insider transactions six months ending/starting three months before and after individual income tax changes.)
In the same way, Ozel said insider trading profits may have declined after the passage of the 2017 Tax Cuts and Jobs Act, which as the name suggests, lowered tax rates and doubled standard deduction for individuals, among other reliefs.
The trajectory of the insider trading profits changed course in line with tax changes, the study found. The JGTRRA cut the ordinary income tax rate on the highest-income taxpayers from 38.6% to 35%, signaling a smaller incentive for insider trading. Sure enough, after the act took effect, the average insider trading profits in the median firm in the study sample declined by $11,183 in the subsequent six months. That was equivalent to 12.6% of the estimated increase in the same insider’s net compensation of $88,290.
But “abnormal trading profits” increased following the enactment of ATRA nine years later, which increased the top ordinary income tax rate bracket from 35% to 39.6%, the study said. The average insider trading profits in the median firm in the study sample jumped to $18,242, which is equivalent to 15.8% of the fall in the same insider’s net compensation of $115,746 annually.
The size of the offset is not higher than the range of 12% to 16%, possibly because of the fear of penal action, Ozel suspected. “Monitoring and enforcement are important determinants of how much insider trading you have,” he explained.
Ozel and Goldman also studied the implications of changes in capital gains taxes on insider trading activity. They found that compared to income taxes, a relatively smaller portion of the income from insider trading is subject to capital gains tax rates. They also find an inverse relationship between the insider trading activity and capital gains tax increases.
“As capital gains tax rate increases, abnormal insider trading profitability should decrease,” the researchers inferred. They cited earlier research that estimated a 2% capital gains tax burden on an average CEO’s total vested equity.
“The goal of our study is to draw some attention from policymakers.” –Naim Bugra Ozel
Lower-paid executives tend to adjust their insider trades in response to tax rate changes more than others that earn more, said Ozel. Insider trading activity was also more pronounced in companies that are relatively low profile and do not attract much media attention, he added. That was true also for companies without too many analysts tracking them. It was the same for companies whose shares have fewer open buy or sell orders (quoted depth tends to be lower when it is likely that some traders privately possess significant information). The industries that saw the most insider trading activity included banks and others in financial services and insurance, machinery, business equipment and retail stores.
Nudge to Regulators
Insider trading scandals in recent memory have featured high-profile cases such as those involving Martha Stewart, Rajat Gupta and Raj Rajaratnam. Insider trading using material, non-public price-sensitive information is both a criminal and civil offense in the U.S. It attracts a prison term of up to 20 years and fines of between $5 million and $25 million, according to Securities and Exchange Commission (SEC) regulations.
“The goal of our study is to draw some attention from policymakers,” said Ozel.
The study has implications for both the tax authorities and the SEC. For the SEC, when the income tax rates are higher, it is a signal for it to invest more in enforcement of insider trading activity, “because the incentives for insider trading increases,” he noted.
One way to do that is to invest more in technology to spread its net wider. “From current research, what we know is that SEC usually investigates large trades or trades that occur frequently,” said Ozel. “It likely doesn’t have the resources to go after the smaller trades or trades that happen once in a while.” Prosecuting investment through illegal insider trading is not an easy job since it calls for sufficient evidence, he noted. “So, the SEC invests its resources to go after the low-hanging fruit.”
For tax policy, the implication of the study is to find alternatives to increasing income tax rates for high earners, since higher rates incentivize insider trading activity at the cost of minority shareholders. Tax policy has usually targeted the top 1% of people in the income spectrum for rate increases. But those people have the resources to avoid the higher tax burdens or “push it down to people who are earning less, such as through insider trading,” Ozel said.
“If there is zero internal monitoring, then insiders can go all the way [in resorting to insider trading] regardless of the tax rate.” –Naim Bugra Ozel
One option for policymakers is to raise capital gains taxes on high earners. “If you raise capital gains taxes, people are not more willing to push those taxes to shareholders by trading on insider information,” Ozel said. “Instead of pushing up the income-tax rates on the top bracket, you may want to increase the capital gains tax rates on them.” This notion is consistent with presidential candidate Joe Biden’s proposal to tax high earners’ capital gains at a higher rate.
The incentive is less for executives to resort to insider trading when capital gains taxes increase, he noted. That is because profits from insider trades are taxed at the capital gains tax rate, and higher capital gains tax rates reduce the benefits executives can get from insider trades, he added.
The study also highlights the need for corporations to strengthen their corporate culture to discourage insider trading by executives with price-sensitive confidential information, and institute internal monitoring processes, said Ozel. “If there is zero internal monitoring, then insiders can go all the way [in resorting to insider trading], regardless of the tax rate,” he said.
Like tax rate increases, the coronavirus pandemic is also “an exogenous shock,” and it may trigger insider trading activity if executives resort to that to offset a fall in their income, Ozel noted.
Future research in this area could look for patterns in the triggers for company executives to resort to insider trading, said Ozel. Researchers could also study the long-term effects of tax rate changes on different components of executive compensation, he added.