Theoretical analysis of non-deductible expenses: Implications for the design of compensation contracts

Abstract

This study analyzes how a tax system, in which expenses associated with business activities are only partially deductible for tax purposes, affects corporate behavior, including the effort level and compensation contracts. Since these activities create firm value and benefit the agent due to the inherent characteristics of consumption goods, the principal faces a trade-off between letting agents work with high-powered incentives and the tax payments resulting from non-deductible expenses. Further, we consider a government's behavior to analyze the case in which the government can flexibly change the non-deductible ratio. We find that the impacts of the corporate tax rate and the agent's preference for activities that incur tax non-deductible expenses depend on whether the non-deductible ratio is flexible. This result partially explains why various countries apply different rules for non-deductible expenses.