Income Taxes and the Composition of Pay: Evidence From the British Household Panel Survey

Abstract

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 Performance‐related pay (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% reduction in the marginal income tax rate, holding the average tax rate constant, increases the share of PRP in total pay by 2.25–3.02%, depending on the empirical specification. Similarly, a 10% reduction in the average income tax rate, holding the marginal tax rate constant, increases the share of PRP in total pay by 5.10–5.27%.

Taxation and agency conflicts between firm owners and managers: a review

“…However, if the wage tax burden is modeled as a function of gross pay with a progressive marginal tax rate, the optimal pay-performance sensitivity varies with the marginal wage tax rate. In this case, an increase in the marginal tax rate implies an increase in the pay-performance sensitivity (Brunello et al 2011). Based on the tax-related results regarding pay-performance sensitivities in the LEN model, Martini and Niemann (2015) analyze the effects of taxation on a human resource assignment decision.…”