Tax-induced distortions of effort and compensation in a principal-agent setting

Common consolidated corporate tax base (CCCTB) and tax allocation via formula apportionment (FA) are hotly debated in the European Union (EU). The objective of this paper is to analyze the tax-induced distortions of managerial incentives and remuneration packages caused by FA. We set up a LEN-type principal-agent model with agents in two different jurisdictions. There are no transactions between the two jurisdictions, thus all findings are driven by FA. If payroll enters the FA formula, the principal demands increased effort and pays an increased compensation to managers in low-tax jurisdictions compared to the benchmark case. Managers in high-tax jurisdictions face the opposite effect. Furthermore, the composition of the remuneration changes, which distorts incentives in addition to the excessive pay. Lastly, net profit increases because FA offers new potential for profit shifting.