Fiscal Treatment of Managerial Compensation - A Welfare Analysis

Abstract

In a principal-agent model, we analyze the consequences of bonus taxes agents need to pay, limited deductibility of bonuses from company pro fits and a corporate income tax (CIT). We explore how these tax instruments affect managerial incentives and how they change the design of incentive contracts used in equilibrium. Introducing bonus taxes decreases the agent's net bonus and reduces effort. Limited deductibility has neither effect. In equilibrium, both instruments reduce the agent's effort and net bonus. Gross bonus payments may increase when a bonus tax is introduced. The CIT has no effect on the incentive contract. In terms of welfare, limited deductibility and bonus taxes are close substitutes. Both lead to a welfare loss compared to a CIT raising the same amount of tax revenue. Welfare can be increased by paying a subsidy for bonus payments.