The Impact of Taxation on Managerial Incentives and the Use of Bonus Banks

Abstract

This study examines how taxes and tax code features influence a firm owner’s use of a managerial incentive scheme known as bonus bank. Bonus banks have a unique property: part of the manager’s earned bonus in one period is withheld and subsequently paid out only in case future period’s firm goals are met. While prior literature on bonus banks either neglected taxes or took managerial incentives as given, I incorporate both aspects into a multi-period agency model with a risk neutral, limited liability agent. The model especially captures corporate income taxes, loss-offset restrictions as well as a manager’s flat, period-dependent income tax rate. The results are twofold: First, compared to fixed remuneration contracts, the use of bonus banks is adversely affected by all investigated taxes and tax code features, except for the loss-offset restrictions. Second, compared to periodical bonus remuneration, bonus banks possess an income smoothing characteristic, weakening the negative effect loss-offset restrictios and income tax progressivity have on a firm owner’s future value. Overall, the results complement the literature on the decision relevance of taxes when designing compensation contracts.

Keywords: Principal Agent Theory, Tax Effects, Bonusbank, multi-periodical contract-structure.