Knowledge that Transforms

aims to appoint a Chair Professor of Finance to provide leadership in all aspects of academic activities, including teaching, research and consultancy in the School of Accounting

We examine the role of cash flow from operations (CFO) in chief executive officer (CEO) cash compensation. We predict that CFO is contract‐relevant in the presence of earnings, and more so when (1) the quality of earnings relative to the quality of CFO as a measure of performance is low and (2) the need for CFO as a financing source is high. Our analysis is motivated principally by normative arguments and anecdotes from financial disclosures linking CFO to managerial effort and contracts, notwithstanding the traditional role of earnings in performance measurement. We find that the weight of CFO in the compensation model is positive and significant in the presence of earnings and stock returns. We also find that the relative quality of CFO compared with that of earnings has a positive (negative) impact on the weight of CFO (earnings). We further find that the relative weight of CFO is enhanced substantially when enterprise activities crucially depend on internally generated cash flow. These findings are unaltered when we include CEO age, firm size, and risk in the model and allow the coefficients to vary across industries.

This study uses an experiment to examine three alternative theoretical explanations for the unintended effects of preannouncements on investor reactions to earnings news. The theoretical explanations are cue consistency, recency effects, and diminishing marginal reactions. The experiment varies the amount of a management preannouncement at five different levels while holding constant consensus analyst expectations prior to the preannouncement and the subsequent earnings announcement. Participants provide preliminary forecasts of current‐ and next‐period earnings per share (EPS) prior to the preannouncement, after the preannouncement, and after the earnings announcement. The pattern of participants' final next‐year EPS forecasts and the results of follow‐up analyses appear most consistent with the predictions of diminishing marginal reactions and, to a somewhat lesser extent, cue consistency, suggesting that both mechanisms play a role in determining the effects of preannouncements. There is little evidence supporting recency effects. Finally, supplemental evidence indicates that participants are unaware that preannouncements influence their reactions to earnings news, suggesting that the effects are unintended. This study has implications for managers who make preannouncement disclosure decisions and for academics who wish to understand and interpret prior research on earnings preannouncements.

This paper uses a strategic tax compliance model to examine taxpayer reporting and tax authority audit strategies in an international setting with two tax authorities. The setting features both information asymmetry between the taxpayer and the tax authorities and inconsistent tax transfer‐pricing rules. The latter creates the possibility of each country trying to tax the same income. We study the effect of the probability of transfer‐price rule inconsistency on the strategies and payoffs of the taxpayer and the tax authorities. We find that an increase in the probability of transfer‐price rule inconsistency induces more aggressive auditing by governments. It therefore deters taxpayers from shifting income to the country with the lower tax rate in situations in which the transfer‐pricing rules are consistent, and can either increase or decrease the income reported to the low‐tax‐rate country in cases in which the transfer‐pricing rules are inconsistent. We find that an increase in transfer‐price rule inconsistency could either increase or decrease the taxpayer's expected tax liability and could either increase or decrease the deadweight loss from auditing. Our results call into question the conventional wisdom that the prospect of double taxation due to transfer‐price rule inconsistency increases a firm's expected tax liability and governments' expected audit costs.

This paper studies how changes in the two key parameters of unemployment insurance—the benefit replacement rate (RR) and the potential benefit duration (PBD)—affect the duration of unemployment. To identify such an effect we exploit a policy change introduced in 1989 by the Austrian government, which affected various unemployed workers differently: a first group experienced an increase in RR; a second group experienced an extension of PBD; a third group experienced both a higher RR and a longer PBD; and a fourth group experienced no change in the policy parameters. We find that unemployed workers react to the disincentives by an increase in unemployment duration, and our empirical results are consistent with the predictions of job search theory. We use our parameter estimates to split up the total costs to unemployment insurance funds into costs due to changes in the unemployment insurance system with unchanged behaviour and costs due to behavioural responses of unemployed workers. Our results indicate that costs due to behavioural responses are substantial.

We use experiments to examine whether the auctioning of entry rights affects the behaviour of market entrants. Standard economic arguments suggest that the licence fee paid at the auction will not affect pricing since it constitutes a sunk cost. This argument is not uncontested though, and this paper puts it to an experimental test. Our results indicate that an auction of entry licences has a significant positive effect on average prices in oligopoly but not in monopoly. These results are consistent with the conjecture that entry fees induce players to take more risk in pursuit of higher expected profits. In oligopoly, entry fees increase the probability that the market entrants coordinate on a collusive price path. In monopoly, taking more risk does not make sense since average prices are already close to the profit-maximizing price.

We study dynamic optimal taxation in a class of economies with private information. Optimal allocations in these environments are complicated and history-dependent. Yet, we show that they can be implemented as competitive equilibria in market economies supplemented with simple tax systems. The market structure in these economies is similar to that in Bewley (1986); agents supply labour and trade risk-free claims to future consumption, subject to a budget constraint and a debt limit. Optimal taxes are conditioned only on two observable characteristics—an agent's accumulated stock of claims, or wealth, and her current labour income. We show that optimal taxes are generally non-linear and non-separable in these variables and relate the structure of marginal wealth and income taxation to the properties of agent preferences.

A monetary union is modelled as a technology that makes a surprise policy deviation impossible and requires voluntarily participating countries to follow the same monetary policy. Within a fully dynamic context, we show that such an arrangement may dominate a regime with independent national currencies. Two new results are delivered by the voluntary participation assumption. First, the optimal plan is shown to respond to a country's temptation to leave the union by tilting both current and future policy in its favour. This yields a non-linear rule according to which each country weight in policy decisions is time-varying and depends on its incentive to abandon the union. Second, we show that there might be conditions such that a break-up of the union, as has occurred in some historical episodes, is efficient. The paper thus provides a first formal analysis of the incentives behind the formation, sustainability, and disruption of a monetary union.

We introduce non-homothetic preferences into an innovation-based growth model and study how income and wealth inequality affect economic growth. We identify a (positive) price effect—where increasing inequality allows innovators to charge higher prices and (negative) market-size effects—with higher inequality implying smaller markets for new goods and/or a slower transition of new goods into mass markets. It turns out that price effects dominate market-size effects. We also show that a redistribution from the poor to the rich may be Pareto improving for low levels of inequality.

Standard theoretical arguments tell us that countries with relatively little capital benefit from financial integration as foreign capital flows in and speeds up the process of convergence. We show in a calibrated neoclassical model that conventionally measured welfare gains from this type of convergence appear relatively limited for the typical emerging market country. The welfare gain from switching from financial autarky to perfect capital mobility is roughly equivalent to a 1 % permanent increase in domestic consumption for the typical non-OECD country. This is negligible relative to the welfare gain from a take-off in domestic productivity of the magnitude observed in some of these countries.