Tax Incentives for Inefficient Executive Pay and Reward for Luck

Posted: 28 Apr 2009

See all articles by Robert F. Göx

Robert F. Göx

University of Zurich - Managerial Accounting; University of Zurich - Faculty of Economics, Business Administration and Information Technology

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Date Written: April, 28 2009

Abstract

I study the economic consequences of tax deductibility limits on salaries for the design of incentive contracts. The analysis is based on an agency model in which the firm's cash flow is a function of the agent's effort and an observable random factor beyond the agent's control. According to my analysis, limiting the tax deductibility of fixed wages has two consequences. The principal rewards the agent on the basis of the observable random factor and adjusts the amount of performance-based pay in the optimal incentive contract. The new contract can have weaker or stronger work incentives than without the tax. The theoretical findings have implications for empirical compensation research. First, the analysis shows that reward for luck can be the optimal response to recent tax law changes, whereas earlier empirical literature has attributed this phenomenon to managerial entrenchment. Second, I demonstrate that a simple regression analysis that fails to control for separable measures of luck is likely to find an increased pay for performance sensitivity as a response to the introduction of tax deductibility limits on salaries even if the pay for performance sensitivity has actually declined.

Keywords: Executive compensation, agency theory, relative performance evaluation

JEL Classification: M40, M52, H32, K34, J33

Suggested Citation

Goex, Robert F., Tax Incentives for Inefficient Executive Pay and Reward for Luck (April, 28 2009). Review of Accounting Studies, Vol. 13, No. 4, 2008, Available at SSRN: https://ssrn.com/abstract=1396150

Robert F. Goex (Contact Author)

University of Zurich - Managerial Accounting ( email )

Plattenstrasse 14
Zurich, CH-8032
Switzerland

University of Zurich - Faculty of Economics, Business Administration and Information Technology ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland

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