Incentive Effects of Bonus Taxes
Abstract: Several countries have implemented bonus taxes for corporate executives in response to the financial crisis of 2007-2010. Using a principal-agent model, this study analyzes how bonus taxes affect the agent's effort, compensation package, tax revenue and social welfare. We show that, contrary to its intention, a bonus tax may even increase the pay-performance sensitivity and decrease the fixed salary component. In addition, a bonus tax can induce the principal to pay higher bonuses even though the agent's effort always decreases. Finally, a bonus tax decreases social welfare unless the social planner puts a sufficiently high weight on tax revenue.