The Combined Impact of Asymmetric Taxation and Limited Liability on Optimal Compensation

We study a binary principal-agent model featuring two risk-neutral parties, in which the agent is protected by limited liability and his compensation is affected by an asymmetric treatment of gains and losses by the tax authority. The model challenges the common wisdom that the principal is always better off whenever the agent is taxed less aggressively. We argue that it depends crucially on the amount of the agent's pledgeable assets whether or not a change in the loss tax rate makes the principal better off. If the agent's pledgeable assets are sufficiently high such that limited liability is not an issue, then an increased loss tax rate leads to a higher tax refund by the tax authority which in turn allows the principal to reduce the cost of compensation without distorting the agent's incentives to work hard. However, if the agent does not own enough pledgeable assets then the principal prefers asymmetric taxation over symmetric taxation. In particular, we find that there exists a loss tax rate such that the principal's welfare is maximized, whereby the loss tax rate is strictly lower than the profit tax rate. Based on our findings we predict that - depending on the amount of the agent's pledgeable assets and the loss tax rate - there is either a positive or a negative correlation between bonuses paid to the agent and the principal's welfare