Incentive effects of bonus taxes in a principal-agent model

Several countries have implemented bonus taxes for corporate executives in response to the current financial crisis. Using a principal-agent model, this paper investigates the incentive effects of bonus taxes by analyzing the agent's and principal's behavior. Specifically, we show how bonus taxes affect the agent's incentives to exert effort and the principal's decision regarding the composition of the compensation package (fixed salary and bonus rate). We find that, surprisingly, a bonus tax can increase the bonus rate and decrease the fixed salary if the agent is highly risk averse. Additionally, a bonus tax can induce the principal to pay higher bonuses even though the agent's effort unambiguously decreases. Nevertheless, a bonus tax reduces the overall salary of the agent. Further results are derived with respect to the existence and uniqueness of the equilibrium for a general effort cost function.

► We develop a principal-agent model where the agent's variable salary is taxed.
► We analyze the incentive effects of such bonus taxes.
► Bonus taxes can increase the bonus rate and decrease the fixed salary.
► Bonus taxes can induce principal to pay higher bonuses despite lower agent effort.