The effects of income taxation on severance pay

Severance pay often results from a bargain between the firm and the employee to avoid or terminate a legal conflict. We theoretically investigate how income taxation affects these negotiations. Using panel data from West Germany and exploiting a change in tax law in 1999, we find that a higher income tax on severance pay reduces the probability of obtaining it and – in some specifications – also lowers its amount. Our results imply overshifting of the increase in the tax burden.