The Effect of Contract Framing on Budgetary Slack and Performance

Abstract

We examine the effect of contract framing on subordinates’ propensity to create budgetary slack and subsequent performance. The contract is designed in economically equivalent penalty and bonus forms, with a reporting bonus (penalty) associated with reporting budgeted production accurately and a production bonus (penalty) associated with beating (not meeting) a budget target. By design, this contract creates a direct link between the budgeting component and the effort (performance) component. In such a setting, the effects of contract framing may lead to different behavioral responses than previously examined or predicted. We find that under bonus-framed contracts individuals create budgetary slack by underreporting their productive capabilities. Consistent with prospect theory, we find evidence that subordinates working under penalty-framed contracts over-report their capabilities. This reporting of optimistic slack is an interesting finding. The results suggest that under penalty-framed contracts subordinates are more likely to over-report their capabilities, whereas subordinates under bonus-framed contracts are more likely to under-report their capabilities. The findings demonstrate that penalty contracts impact how individuals report their capabilities, suggesting that penalty contracts may be more advantageous than bonus contracts in some settings.