An unintentional consequence of taxation: Tax cuts and vertical pay dispersion

Abstract We study the effect of tax cuts on the pay dispersion between firms’ executives and rank‐and‐file employees. Using the 2009 value‐added tax (VAT) reform in China as a quasi‐experimental setting, we find that tax cuts are associated with increased vertical pay dispersion, which is an unintentional consequence. We also find that managerial power intensifies the effect of tax cuts on vertical pay dispersion, consistent with the view that the increase in pay dispersion is due to managerial rent extraction. Furthermore, our results are not driven by executives’ higher pay‐for‐performance sensitivity than rank‐and‐file employees. In addition, we find that the VAT reform significantly increases pay dispersion driven by noneconomic factors but has no significant impact on dispersion driven by economic factors. Overall, our results support the rent‐extraction channel for the effect of tax cuts on income inequality.