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The Effects Of Bonus Taxes On Executive Compensation

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Executive Summary

The financial crisis from 2007-2010 was the worst crisis since the Great Depression. Politicians, economists and regulators search for measures to avoid such a crisis to repeat. One prominent proposal is the introduction of bonus taxes for corporate executives. In this paper, the authors analyze the effects of such a bonus tax on executive compensation in a principal-agent model. This paper shows that a bonus tax can induce the principal to offer higher bonuses even though the agent always reduces his effort. The tax-induced effort reduction by the agent decreases with an increase in the agent's risk aversion or the degree of uncertainty.

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