Incentives, Cost Allocation and Taxes in a Multi-task Setting

Abstract

This paper investigates strategic cost allocation in a single-period principal-agent setting, where the principal has two contractible performance measures available for contracting and the agent controls two productive tasks subject to moral hazard. In this setting, cost allocation shifts profit between the two performance measures (or between two taxable entities). There are two sources of error in cost allocation: random noise and strategic cost allocation under the agent's control. We first provide conditions under which such cost allocation errors lead the principal to abandon cost allocation and rely on a simple aggregate performance measure. We next consider a setting where the two performance measures represent divisional profits that are taxed at different rates. In this setting, the agent's ability strategically shift costs between the divisional performance measures is beneficial to the principal and leads to different relative performance weights for the two divisional performance measures.