Agency costs and income taxation

Abstract

This paper analyzes agency costs and the moral hazard problem in the presence of income taxation. As basic framework, income taxes are integrated in the hidden action model of agency theory. In the case of symmetric information no agency costs occur, i.e. optimal risk-sharing can be achieved, if and only if the tax is proportional. It is well-known that asymmetric information causes a welfare loss, termed agency costs, even if no taxes are imposed. Introducing a proportional income tax now increases (decreases) these agency costs if the agent exhibits decreasing (increasing) absolute risk aversion. Additionally, we show that non-proportional taxes cause higher (lower) agency costs than a proportional tax if the agent’s marginal tax rate exceeds (is smaller than) the marginal tax rate of the principal.