Agency cost of debt as incentive for executive inside debt: Evidence from empirical study

Abstract

The substantial holdings of inside debt cause both academia and industry to wonder about the reasons. Jensen and Meckling (1976) suggest that debt-like compensation could lower the agency cost of debt. Nevertheless, empirical evidence is still lacking for whether the management really chooses to use inside debt as mitigation of agency cost of debt. In this study, the author uses the value of non-tax-deductible deferred compensation from the ExecuComp database as the measure of inside debt, leverage as the proxy for agency cost of debt, and examines the causal effect of changes in leverage on inside debt. Using phased increases in corporate income taxes in US states between 2006 and 2016 using difference-in-differences regression, the author identifies the causal effect of tax-motivated corporate leverage on the balance of deferred compensation. Firms increase their deferred compensation balance by $85,000 with a 1% increase in leverage. This finding implies changes in the agency cost of debt as a potential reason for variations in inside debt values and provides evidence for Jensen and Meckling’s (1976) theory.