Labor Skill and Income Smoothing

We examine whether, when, and to what extent the skilled labor required by firms affects managers’ income smoothing activities. Consistent with our hypothesis that managers smooth earnings to signal their diminished risk and improve long-term relationships with high-skill employees, we show that the level of labor skills required by firms is positively associated with managers’ income smoothing activities. We address endogeneity concerns by exploiting subsamples of firms with similar firms and industry characteristics and a quasi-experimental shock to labor markets led by Hurricane Katrina. The effect of labor skills on income smoothing is weaker for firms granting employee stock options and notably stronger for firms operating in competitive product markets. Finally, we document that future employment volatility decreases as a consequence of income smoothing, suggesting that managers’ income smoothing activities reduce the turnover of skilled employees and help to maintain their employment at a stable level.