The effect of tax policy uncertainty on incentivization, managerial effort and total surplus

Abstract This paper examines the effect of tax policy uncertainty on incentivization and managerial effort in an agency model with risk-averse principal and agent. If the agent’s effort is unobservable, the agent’s variable share of profit acts as a risk-sharing and incentivizing instrument. Then, a countercyclical tax base policy at the agent level or a procyclical policy at the principal level can increase the agent’s variable share of profit, whose increase in turn increases the agent’s effort. This theoretical finding favors a procyclical tax policy at the company level (principal) and a countercyclical one at the employee level (agent). Tax policy uncertainty in the sense of tax base risk makes this increase in effort possible and strengthens effects. Additionally, under a countercyclical tax base policy at the agent level, tax base risk at the agent level up to a certain level increases overall utility and thus total surplus.