Loss-Offset Restrictions, Progressive Wage Taxation and Performance-Based Incentive Contracts

Bonus contracts are predominant in management remuneration. These contracts reward managers with variable payments in case of satisfactory performance. However, penalty contracts, which punish target failure with financial deductions, could be a competitive alternative. Nevertheless, they do not prevail in corporate practice. One reason could be the tax treatment at the individual level. We analytically examine the effects of the most common forms of corporate and personal income taxation on a firm owner's contract choice. These forms comprise corporate taxation without and with loss-offset restrictions and proportional and progressive wage taxation. Our findings show that loss-offset restrictions at the company level do not systematically impede penalty arrangements. This asymmetric corporate taxation does not provide an explanation why penalty contracts are used less often than bonus contracts in corporate practice. However, progressive wage taxation tends to discourage penalty contracts compared to bonus contracts