Do taxes explain why firms rarely use penalty remuneration contracts?

Almost everybody has heard of bonus contracts in executive remuneration before, probably through newspaper articles that condemn excessively high payments for managers. Bonus contracts follow incentive mechanisms that are supposed to align the potentially diverging interests of firm owners and managers. These contracts link the attainment of performance targets to variable financial rewards but seem to meet societal disapproval quite frequently. Especially the Global Financial Crisis of 2008 triggered demands for new practices in the remuneration of executives. Different institutions across the world, such as the Organisation for Economic Co-operation and Development, the European Parliament or the Commission on the German Corporate Governance Code have started proposing contracts with penalty clauses—sometimes also called malus clauses—as alternative remuneration devices. Penalty contracts reduce the pay-out of variable remuneration in case of target failure and offer two main advantages. First, they have the potential to curb excessive remuneration; second, they could contain risk-taking behaviour that might cause new crises.

Why don’t we see penalty contracts more often?

Despite the wide demand for such penalty contracts and their supposed benefits, they are not nearly as widespread as bonus contracts in executive remuneration. A reason for this phenomenon might lie in taxation. Prior research on the effects of taxation on incentive systems for managers and anecdotal evidence, show that taxation can have substantial impact on corporate governance decisions within firms. Moreover, it can have side effects that the tax legislator did not intend. Hence, we take a closer look at the effects of taxation on the firms’ choice between bonus and penalty contracts when hiring and remunerating an executive manager.

The reasons: Taxes can have something to do with it!

Our paper ‘Do Taxes Explain Why Firms Rarely Use Penalty Remuneration Contracts?’ is addressed to both researchers and practitioners, who want to break new ground and implement a remuneration and incentive scheme that has earned societal approval. We use a mathematical model to isolate the effects of taxation and find that bonus and penalty contracts are equivalent options with regard to their main purpose of motivating the desired managerial effort. Our analyses reveal that tax conditions could indeed help to explain why penalty contracts are underrepresented compared to bonus contracts. In particular, the implementation of loss-offset restrictions for companies and progressive wage taxation for executive managers interfere with the firm’s contract choice.

At the company level: loss-offset restrictions

Tax systems all over the world feature loss-offset restrictions. They literally restrict companies’ possibilities to offset losses against past or future profits for tax purposes. Thereby, they distribute risks asymmetrically between the tax authorities and the companies, as the treasury participates in profits fully and immediately. Hence, loss-offset restrictions cause losses to be an even heavier burden for the company. In cases of restricted loss-offset, penalty contracts tend to become less attractive to firms. Since these contracts limit upward payment potential, they need to feature higher base payments to remain an attractive contract alternative for an executive manager. This higher base payment weights even more on the company in situations with losses.

At the employee level: progressive wage taxation

Similarly, progressive wage taxation is used globally for redistribution within a society. It requires an employee to pay a higher average tax rate for increasing income. However, the firms bear this tax burden, especially for highly skilled executive managers with many outside options, by raising the gross remuneration to a level that ensures satisfaction of the manager with the remaining net income. Again, due to their remuneration structure, penalty contracts can become less attractive to the firm, as they require higher outbalancing of wage tax payments in expectation. To prevent undesired and unintended side effects of progressive wage taxation, we calculate contract-adjusted wage tax rates on the respective payments to maintain the equal attractiveness of bonus and penalty contracts.

Loss-offset restrictions and progressive wage taxation are common in many tax systems all over the world. They impede the usage of penalty remuneration contracts for company managers and make it harder for firms to follow corporate governance recommendations.

Rainer Niemann is Professor at the University of Graz and Head of the Institute of Accounting and Taxation.

Mariana Sailer is an Assistant Professor at the Institute for Accounting & Auditing at the Vienna University of Economics and Business.