Performance-Based Incentive Contracts under Asymmetric Taxation

Abstract

Manager remuneration is usually linked to a performance-based incentive contract. However, finding and implementing the optimal performance-based incentive contract after taxes can be difficult if business forecasts or tax conditions are complex. Bonus and penalty contracts might be easier-to-implement alternatives to optimal contracts and are already used in practice or widely demanded. We analytically examine the impact of symmetric and asymmetric corporate taxation, i.e. taxation without and with loss-offset restrictions, on the principal’s contract choice. We find that symmetric taxation is neutral with respect to contract choice. By contrast, asymmetric taxation can alter the ranking of different performance-based remuneration contracts. Our numerical simulations show that a contract that is optimal under symmetric taxation closely approximates an optimal contract under asymmetric taxation. However, both bonus and penalty contracts can be even better approximations, depending on the parameter setting. Due to their simple determination, bonus and penalty contracts can limit tax planning costs and therefore be reasonable with regard to cost-benefit considerations.

Keywords: performance-based remuneration, penalty contracts, asymmetric taxation, principal-agent model

JEL Classification: D86, H21, M41