Agency, Incentives, and Motivating Innovation

Abstract

Much of our understanding of motivating innovation builds on the conceptual idea that agency conflicts affect decisions on innovative activities, but empirical evidence on this fundamental relationship is scarce. This paper exploits an identification strategy using an exogenous cut to the taxation on managers’ dividend and capital gains income from the employer firm, which increases the after-tax value of those income. The agency effect on innovation is quantified by comparing heterogeneous behaviors after the tax cut among firms whose managerial ownership is low (insensitive to the event), medium (moral hazard is mitigated), and high (managerial risk aversion is exacerbated). I find that mitigating moral hazard stimulates innovation input and output quantity, while aggravated managerial risk aversion impedes innovation quantity. Managerial risk aversion shifts innovation directions to safer and more incremental paths, and merely alleviating moral hazard problem does not solve this issue. In response to agency shocks, firms adjust their innovative labor and organizational structure of innovation investment to achieve the documented changes. The agency effect on motivating innovation is sensibly governed by corporate governance, compensation structure, and CEO characteristics.