Income Taxes and Managerial Incentives: Evidence from Hedge Funds

We find a negative relation between hedge fund manager’s personal income tax rates and fund performance. Using changes in tax deferral regulation or state-level tax rates suggest causality in the tax-performance relation. Managers are less likely to hold stocks with greater information asymmetry when faced with higher tax rates, consistent with higher taxes disincentivizing managers to engage in more demanding acquisition and processing of information. However, higher incentives from compensation contracts and co-ownership can help investors mitigate the deterioration in fund performance from higher taxes. Overall, our findings are consistent with higher taxes reducing managers’ work incentives.