The Effect of Endogenous Contract Selection on Budgetary Slack: An Experimental Examination of Trust, Distrust, and Trustworthiness

Abstract

We examine the effect of endogenous contract selection on budgetary slack using two slack-inducing contracts found in the literature: a trust contract where the superior must accept the subordinate’s budget and a discretion contract where the superior can accept or reject the budget. Because neither contract incorporates a formal control for budgetary slack, we apply insights from both agency theory and social norm theory to develop our theoretical expectations. We hypothesize and find that budgetary slack is lower for both contracts when they are endogenously selected by the superior than when they are exogenously assigned. Consistent with our theoretical expectations, exit questionnaire responses suggest that selecting a trust contract signals trust and expectations of trustworthiness whereas selecting a discretion contract signals distrust and an increased willingness to enforce trustworthiness by rejecting unreasonable budgets. Signaling distrust, however, appears optimal for superiors in our budgeting setting. In particular, far more superiors select the discretion contract under endogenous contract selection and doing so yields the efficiency of the optimal hurdle contract prescribed under traditional agency assumptions.

Keywords: endogenous contract selection, trust, distrust, trustworthiness

JEL Classification: C91, D83, M40