According to the standard principal – agent model, the optimal composition of pay should balance the provision of incentives with the individual demand for insurance. Do income taxes alter this balance? We show that the relative share of PRP on total pay is reduced by higher average and marginal income taxes. Empirical evidence based on the British Household Panel Survey is consistent with the theoretical predictions of the tax – augmented principal-agent model. Our estimates suggest that a 10 percent reduction in the marginal income tax rate, holding the average tax rate constant, increases the share of PRP in total pay by 2.87 percent. Similarly, a 10 percent reduction in the average income tax rate, holding the marginal tax rate constant, increases the share of PRP in total pay by 5.30 percent.
- performance related pay,
- income taxes,