Why Taxing Executives’ Bonuses Fosters Risk-Taking Behavior

The following post comes to us from Martin Grossmann, Markus Lang, and Helmut Dietl, all of the Department of Business Administration at the University of Zurich. Work from the Program on Corporate Governance on executive compensation includes Paying for Long-Term Performance by Bebchuk and Fried.

In the paper, Why Taxing Executives’ Bonuses Fosters Risk-Taking Behavior, we analyze the effect of a bonus tax on the risk-taking behavior of corporate executives in a principal-agent model. In our paper, the firm value (output) depends on the manager’s behavior in two dimensions. First, the manager can increase the firm value by exerting more effort. Second, the manager can choose a project with specific exposure. A project choice with a higher expected return simultaneously implies a higher risk. Therefore, the project choice influences the expected value as well as the variance in the output. For instance, bank managers dealing with credits face this kind of trade-off.

Credit at low interest rates can be assigned to firms with high ratings. Therefore, the bank has low expected profits but also low risks. Otherwise, credit at higher interest rates can be assigned to a start-up firm operating in a promising area but with high uncertainty. Thus, a higher expected return can be achieved by being exposed to higher risks. We assume that the principal offers a salary package consisting of a fixed salary and an incentive-based component (bonus rate). The bonus rate increases with the manager’s output. As the manager can only influence the output by his effort choice and the degree of exposure, the realization or failure of the project is stochastic.

Our model shows that the introduction of a bonus tax unintentionally intensifies the manager’s risk-taking behavior and decreases the manager’s effort. On the one hand, a higher tax decreases the marginal revenue of risky projects, but on the other hand, it also decreases the variance in the manager’s salary, implying lower marginal costs. The second effect dominates the first and therefore a higher bonus tax induces the manager to increase his risk-taking behavior. Simultaneously, the manager decreases his effort because a higher bonus tax decreases the marginal revenue of effort. We further show that a higher bonus tax shifts the compensation package from the incentive-based component to the fixed salary.

Finally, a higher risk aversion of the manager and/or a higher variance in the firm value induces the manager to increase his effort and to decrease his risk-taking behavior, while the principal increases the bonus rate. Our results imply that a government should be careful when evaluating whether a bonus tax is an accurate instrument to introduce in order to prevent the excessive risk-taking behavior of corporate executives. This article is a first step in analyzing the effects of a bonus tax on risk-taking behavior. We encourage further research in this area.

The full paper is available for download here.

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