Performance-Based Incentive Contracts under Asymmetric Taxation

Bonus contracts are predominant in management remuneration. These contracts reward managers with variable payments in case of satisfactory performance. However, penalty contracts that include financial deductions in case of unsatisfactory performance are rarely used in practice despite their public demand. To evaluate their potential of incentive provision in a tax-world, we employ a discrete principal-agent model to examine how symmetric and asymmetric corporate taxation influence a company owner’s choice between performance-based remuneration contracts. We find that symmetric corporate taxation is neutral with respect to the decision between an optimal pre-tax benchmark, a bonus and a penalty contract. In contrast, asymmetric taxation distorts this decision and can make the previously optimal contract inferior to either the bonus or the penalty contract, underlining its potential in incentive provision.