Topic: Economic Policy
On Congress's Tax on Bonus Pay The relationship between Bonus Pay, incentives, and tax distortions on assymetric information.by Jeff Peters
(conservative)
Sunday, March 22, 2009
First, President Obama has imposed a cap on Executive Pay. Now, companies that receive funds from the Federal government will face 90% taxes on their bonuses. Of course we must question whether or not congress made the right move.
What are the roles of bonuses? Sure, bonuses reward people for how much the company grows and improves over time. Fine! But there's a hell of a lot more to the world of compensation than one may believe.
The most important aspect of building a business is producing goods and services based on profitability and costs. Every firm wants to have a structure that incentivizes its employees to produce what they can for profit maximization and growth.
A main problem that arises with finding the best incentivizing structure is figuring out the productive abilities of employees. The statement implies the existence of heterogeneity of employees within the labor force and market, which brings about greater concerns on the side of the firm.
The reason is very clear. If all members of some labor market were of equal productivity there would be no need to differentiate pay for laborers. However, if there's heterogeneity then the firm will have to go about differentiating pay and dealing with solving the problem of asymmetric information. This makes hiring a science and makes compensation packages more interesting.
Because this asymmetric information problem is always around, the firm has to maintain incentives for employees to work. The same happens for CEO's and executives; shareholders want to make sure that their executives are doing what they need to do in order to raise the value of their company. That is the role of bonuses.
What is interesting about bonuses is something not immediately important: when bonuses are given. The best way for shareholders to assure their stock value increases is to first observe the performance of their executives and then compensate them for overall firm improvements. Thus, bonuses, as deferred compensation, provide incentives for executives to keep working hard and improving overall company performance.
Congress's tax on bonuses creates a disincentive for executives and other employees to maximize future performance. More importantly, it distorts the ability of the firm and market to analyze worker performance and will risk dislocation of talent in the market just like caps on executive pay.
If there's anything that hurts the market, that is intentional misallocation of scarce resources.
There is one thing that makes me very happy about the restrictions imposed on companies that will decide to accept bailout funds: it may incentivize firms to deal with their problems on their own!
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The views expressed in this
article are those of Jeff Peters only and do not represent
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