Performance Measure Properties and the Effects of Incentive Contracts

Abstract

Using data from a third-party survey on compensation practices at 151 Dutch firms, we show that less noisy or distorted performance measures and higher cash bonuses are associated with better-directed effort and improved employee selection. Specifically, 1) an increase in the cash bonus increases the selection effects of incentive contracts, but does not independently affect the effort that employees deliver, and 2) performance measure properties directly impact both effort and the selection functioning of incentive contracts. These results hold after controlling for an array of incentive contract design characteristics and for differences in organizational context. Our estimation procedures address several known problems with using secondary datasets.