Labor Skills and Income Smoothing

Abstract

We examine whether labor skills affect managers’ income-smoothing activities. We hypothesize firms that rely on skilled labor have greater incentives to smooth earnings to reduce labor turnover and facilitate replacements. Consistent with our hypothesis, we find that firms’ labor skills are positively associated with managers’ income-smoothing activities. Leveraging the staggered rejection of the Inevitable Disclosure Doctrine (IDD) by 16 U.S. states, which exogenously increases external job opportunities for high-skill employees, we find that the positive relation between labor skill and income smoothing is stronger for firms in the IDD rejection states. Our results are also stronger during nonrecession periods characterized by higher differential costs of turnover between high-skill and low-skill employees and robust to controlling for employees’ education. The mechanism for the positive relation between labor skills and income smoothing is attributable to the higher cost incurred by firms in the turnover of high-skill labor compared with low-skill labor and is consistent with the information-garbling story. Furthermore, we show that future employment volatility decreases with income smoothing. Collectively, our findings are consistent with the view that income smoothing stabilizes skilled workers’ employment by reducing turnover and facilitating the hiring of replacements. JEL classification: J24; G30; M41; M54.