Ebook The Effect of Personal Income Tax on Corporate Agency Costs
In one of the seminal papers on agency theory, Jensen and Meckling (1976) define an agency relationship as “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent.” They also note that since the agent’s goal is to maximize his own utility, we can expect some divergence between the agent’s decisions and those decisions that would maximize the welfare of the principal. This divergence of interests is the ‘agency problem’ that is faced by principals.
In the corporate context, and in the simplest form, the principal is the shareholder and the agent is an employee manager who is compensated with a wage for his managerial services. The manager has discretion over many decisions that will affect both the benefits that flow to the shareholder (i.e. dividends, capital appreciation) and the utility that the manager will derive from his employment. For example, the manager has at least some discretion over the perquisites he will consume, how hard he will work and operational decisions that affect the prestige of his position and the risks that he will face. In order to maximize his own utility, the manager may sacrifice potential profits and shareholder benefits. The dollar cost of these lost shareholder benefits is known as the residual loss and is the type of agency cost that is dealt with in this paper.
Much of the previous research, both theoretical and empirical, has focused on how agency costs may be affected by the ownership structure, the system of corporate governance (board structure, voting rights, etc.), management compensation methods and the legal environment under which the firm operates. Comprehensive reviews of agency related research are provided by Shleifer and Vishny (1997) and Denis (2001).
The agency theory research to date has largely ignored the effect that personal taxation may have on agency costs. This is surprising given the general manner (or at least theoretical manner) in which principals attempt to control agency costs. Principals may attempt to align management’s interests by monitoring performance and rewarding good decision-making (and/or punishing poor decision-making). The reward takes the form of an upward adjustment to the agent’s compensation (i.e. bonuses, raises and promotion), while the punishment would involve reduced compensation (i.e. demotion, withholding normal raises or bonuses, dismissal).
The manager thus has a compensation related incentive to perform well. However, higher levels of performance require that the manager consume less non-pecuniary benefits (i.e. consume fewer perquisites, enjoy less leisure time, tolerate more stress, etc.). Therefore, better performance is associated with higher expected pecuniary benefits, but lower non-pecuniary benefits. The agent manager will choose a performance level that maximizes his overall expected utility from both pecuniary and non-pecuniary benefits. Given the direct effect that personal taxation has on the utility associated with a given level of compensation, it seems obvious that taxation must have some effect on the manager’s preferred performance level and hence the agency costs that the principal must absorb.
This paper develops and analyzes a simple agency model in order to predict the potential effect that personal taxation has on agency costs. In the one period model that follows, a representative employee manager chooses a level of performance to maximize his personal expected utility. Performance is defined in terms of how well the manager controls the net cost to the firm of non-pecuniary benefits (higher performance relates to lower agency costs). The manager faces uncertainty in terms of how his actual performance will be perceived since, as discussed by Alchian and Demsetz (1972), the principal is not capable of perfectly measuring performance. In light of this, measured performance is assumed to be an unbiased normally distributed estimate of actual performance.
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