Do Taxes Explain Why Firms Rarely Use Penalty Remuneration Contracts?

Abstract

Bonus contracts trigger financial rewards in case of goal attainment, which sometimes reach socially undesired amounts. In contrast, penalty contracts punish target failure by means of financial deductions. Demanded by various stakeholders, penalty contracts could be a competitive alternative that curbs high executive remuneration—nevertheless, they do not prevail in corporate practice. A reason for this could lie in the tax treatment of losses and remuneration. We analytically examine the effects of the most common forms of corporate taxation (symmetric and asymmetric) and personal wage taxation (proportional and progressive) on a firm owner’s contract choice. Our findings show that neither symmetric corporate nor proportional wage taxation impede penalty arrangements. However, asymmetric corporate taxation tends to disadvantage penalty contracts compared to bonus contracts. Furthermore, progressive wage taxation has the potential to make penalty contracts less attractive. This insight can add to the explanation of why penalty contracts are rarely used in executive remuneration.

Keywords: bonus contracts, penalty contracts, asymmetric corporate taxation, progressive wage taxation

JEL Classification: D86, H21, M41