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A study on the incentive compensation structure with payroll tax: A continuous-time principal-agent model

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  • Wang, Huan
  • Lai, Chong
  • Lai, Shaoyong

Abstract

This paper studies a case when the government levies a payroll tax on the employee (agent) of an enterprise. We use a continuous-time principal-agent framework to analyze the impact of the tax on the employee’s working strategy and derive an incentive compensation scheme. The agent is supposed to be aware of his pre-tax and after-tax salary. Under the theory of behavioral economics, loss caused by taxation is taken into consideration. The Hamilton-Jacobi-Bellman (HJB) equation of principal’s profits is derived. By exploiting the HJB equation, we get several properties of the optimal contract. We also perform comparative statics to show our results. The model suggests that the agent’s utility loss enlarges as the tax rate increases. However, an increase in the tax rate does not always decrease principal’s profits.

Suggested Citation

  • Wang, Huan & Lai, Chong & Lai, Shaoyong, 2021. "A study on the incentive compensation structure with payroll tax: A continuous-time principal-agent model," The North American Journal of Economics and Finance, Elsevier, vol. 58(C).
    • Handle: RePEc:eee:ecofin:v:58:y:2021:i:c:s1062940821001091
    DOI: 10.1016/j.najef.2021.101489
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    More about this item

    Keywords

    Principal-agent model; Payroll tax; Incentive compensation; Utility loss;
    All these keywords.

    JEL classification:

    • H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies
    • J30 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - General
    • M52 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects

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