FALL 2020 NEW YORK UNIVERSITY SCHOOL OF LAW “Redistribution With Performance Pay.” Abdoulaye Ndiaye NYU Stern Business School November 17, 2020 Via Zoom Time: 2:00 – 3:50 p. EST Week 12 SCHEDULE FOR FALL 2020 NYU TAX POLICY COLLOQUIUM (All sessions meet online on Tuesdays, from 2:00 to 3:50 pm EST) 1. Tuesday, August 25 – Steven Dean, NYU Law School. “A Constitutional Moment in Cross-Border Taxation.
Tuesday, September 1 – Clinton Wallace, University of South Carolina School of Law. “Democratic Justice in Tax Policymaking. Tuesday, September 8 – Natasha Sarin, University of Pennsylvania Law School. “Understanding the Revenue Potential of Tax Compliance Investments.
Tuesday, September 15 – Adam Kern, Princeton Politics Department and NYU Law School. “Illusions of Justice in International Taxation. Tuesday, September 22 – Henrik Kleven, Princeton Economics Department. “The EITC and the Extensive Margin: A Reappraisal.
Tuesday, September 29 – Leandra Lederman, Indiana University Maurer School of Law. “Of Risks and Remedies: Best Practices in Tax Rulings Transparency. Tuesday, October 6 – Daniel Shaviro, NYU Law School. “What Are Minimum Taxes, and Why Might One Favor or Disfavor Them?” 8.
Tuesday, October 13 – Gabriel Zucman, University of California, Berkeley. “The Rise of Income and Wealth Inequality in America: Evidence from Distributional Macroeconomic Accounts. Tuesday, October 20 – Michelle Layser, University of Illinois College of Law. “How Place-Based Tax Incentives Can Reduce Economic Inequality.
Tuesday, October 27 – Steve Rosenthal and Theo Burke, Urban-Brookings Tax Policy Center. “Who's Left to Tax? US Taxation of Corporations and their Shareholders. Tuesday, November 10 – Owen Zidar, Princeton Economics Department. “The Tax Elasticity of Capital Gains and Revenue-Maximizing Rates.
Tuesday, November 17 – Abdoulaye Ndiaye, NYU Stern Business School. “Redistribution With Performance Pay. Tuesday, November 24 – Lilian Faulhaber, Georgetown Law School. “Searching for Coherence: The Overuse of Excess Returns and Excess Profits.
Tuesday, December 1 – Erin Scharff, Arizona State Sandra Day O’Connor College of Law. “Revisiting Local Income Taxes.” Redistribution with Performance Pay* Paweª Doligalski Abdoulaye Ndiaye Nicolas Werquin University of Bristol New York University Toulouse School of Economics May 21, 2020 Abstract Half of the jobs in the U. feature pay-for-performance. We study nonlinear in- come taxation in a model where such labor contracts arise as a result of moral hazard frictions within rms.
We derive novel formulas for the incidence of arbitrarily nonlin- ear reforms of a given tax code on both average earnings and their sensitivity to output risk. We show theoretically and quantitatively that, following an increase in tax pro- gressivity, the higher sensitivity of earnings to performance caused by the crowding-out of private insurance is almost fully oset by a countervailing performance-pay eect driven by labor supply responses. As a result, earnings risk is hardly aected by pol- icy. We then turn to the normative analysis of a government that levies taxes and transfers to redistribute income across workers with dierent levels of uninsurable pro- ductivity.
We nd that setting taxes without accounting for the endogeneity of private insurance is close to optimal. Thus, the common concern that standard models of tax- ation underestimate the cost of redistribution is, in the context of performance-based compensation, overblown. * We thank Árpád Ábrahám, Gadi Barlevy, Katherine Carey, Antoine Ferey, Xavier Gabaix, Daniel Garrett, Louis Kaplow, Stefan Pollinger, Morten Ravn, Kjetil Storesletten, Florian Scheuer, Karl Schulz, Stefanie Stantcheva, Aleh Tsyvinski, Hélène Turon, Venky Venkateswaran, Philipp Wangner, and numerous seminar and conference participants, for helpful comments and suggestions. Nicolas Werquin acknowledges support from ANR under grant ANR-17-EURE-0010 (Investissements d'Avenir program).
Introduction What do fruit harvesters, real estate brokers, bankers and CEOs have in common? All of them are paid based on their performance. Performance-pay contracts have become increasingly popular across the income distribution. Empirically, a large share roughly half of all the jobs in the U. involves performance-based compensation (Lemieux, MacLeod, and Parent (2009)) in the form of piece rates, commissions, bonuses, and stock options.
These contracts are qualitatively dierent from usual wage contracts. Indeed, the structure of earnings is designed not only to compensate the employee for completing the job, but also to provide incentives for eort in the rst place. When wages are highly sensitive to performance incentives are high- powered employees are generously rewarded for better outcomes, but at the same time they are also more exposed to risk. Crucially, we expect both the level and the performance-sensitivity of these contracts to be endogenous to the tax policy implemented by the government.
Yet despite the prevalence of these compensation schemes, they have not been systematically studied in the taxation literature. We ll this gap. In a general and tractable framework we derive in closed form the incidence of tax reforms on the earnings and utility that performance-pay workers receive in equilibrium. We also derive the impact of taxes on government revenue and social welfare, as well as the optimal rate of tax progressivity in the presence of such realistic labor contracts.
A widespread concern is that traditional models of income taxation in the tradi- tion of Mirrlees (1971) substantially overstate the optimal level of taxes, by assuming that heterogeneity in wage rates is exogenous and policy-invariant. 1 Instead, when wage risk is endogenous, increasing the progressivity of income taxes should lead to a crowding-out of private insurance provided by rms, that is, a one-for-one spread of the pre-tax earnings distribution. Theoretically, this crowding-out has been shown to be of critical importance in various contexts in particular by Attanasio and Ros- Rull (2000), Golosov and Tsyvinski (2007), and Krueger and Perri (2011) where it severely limits the ability of governments to provide social insurance. Empirically, evidence of such crowding-out has been highlighted in several markets, for instance unemployment or health insurance see Cullen and Gruber (2000); Schoeni (2002); 1 This is the case both in the static (for instance Saez (2001)) and dynamic (for instance Golosov, Kocherlakota, and Tsyvinski (2003); Farhi and Werning (2013); Golosov, Troshkin, and Tsyvinski (2016)) frameworks.
1 Cutler and Gruber (1996a,b). Yet the empirical literature that studies the impact of income taxes on the structure of performance-pay contracts often fails to nd sig- ni cant crowding-out eects, see for instance Rose and Wolfram (2002); Frydman and Molloy (2011). Our paper reconciles these ndings by highlighting a counter- vailing force that keeps earnings risk practically unaected by tax policy. This novel performance-pay eect is driven by labor supply adjustments.
Under a more pro- gressive tax code, the worker's optimal level of eort is lower. The rm elicits this labor supply reduction by providing more insurance (crowding- in ). We nd that this performance-pay eect almost fully osets the crowding-out. We set up a model in which income inequality arises from two distinct sources, namely, innate ability dierences, and ex-post performance shocks that aect the out- put of equally talented workers.
While the former source of wage disparities cannot be insured by private markets, the latter is very much shaped in the labor market. In the presence of moral hazard frictions, wage risk has a productive role: employers choose the amount of risk faced by their employees through performance-based pay contracts in order to strike a balance between insurance and incentives for eort. Our modeling of labor markets is based on those of Edmans and Gabaix (2011) for our static setting, and Edmans, Gabaix, Sadzik, and Sannikov (2012) for our dynamic set- ting. Their frameworks have been very successful at explaining the empirical features of actual performance-based contracts (see Edmans and Gabaix (2016)).
We extend them to incorporate sophisticated nonlinear policy instruments. The key technical breakthrough is that we allow for arbitrarily nonlinear tax instruments. Previous models of moral hazard were tractable only under very restricted forms of the utility of consumption for instance, Holmstrom and Milgrom (1987) impose exponential utility functions. This makes it impossible to consider a wide class of tax schedules typically, they would have to be restricted to being a ne since nonlinear taxes eectively modify the concavity of the utility that workers receive from their salaries.
Instead, the analysis of Edmans and Gabaix (2011) remains tractable for very general utility functions. Therefore it allows us to study the incidence of arbitrary tax reforms (say, increasing taxes on the rich, or altering the shape of the EITC) of any initial tax schedule (say, the U. Our analysis is thus very general and can be used for both positive and normative investigation. The government has an eective role to play despite the fact that private insurance markets are constrained e cient.
Indeed, while rms optimally provide insurance against ex-post output risk, the government 2 uses tax policy for redistribution between workers with dierent ex-ante ability. We start with a positive analysis of the incidence of tax reforms on the workers' labor contracts and the distribution of utilities. In standard models with exogenous wage risk, taxes aect earnings only by modifying individual labor eort decisions. In our framework, wage risk is endogenous to policy as well.
We show that it responds to tax changes via two channels: a crowding-out eect, and a performance-pay eect. On the one hand, the crowding-out eect is the optimal response of rms to a change in social insurance: they adjust the earnings contract endogenously so that the workers' incentives for eort and participation constraints remain satis ed after the reform. Thus, following an improvement in social insurance (higher tax progressivity), rms respond by spreading the pre-tax earnings schedule. The performance-pay eect, on the other hand, arises from the optimal labor supply adjustment to the tax reform.
As in standard models of income taxation, workers' optimal eort is lower in response to an increase in marginal tax rates or tax progressivity. But eliciting a lower eort level in the presence of moral hazard frictions is achieved by lowering the sensitivity of pre-tax earnings to performance, that is, by compressing the wage distribution. This eect counteracts the direct crowding-out of private insurance that the tax reform induces. Crucially, because our model is tractable, we are able to derive this tax incidence analysis entirely in closed form for an arbitrary baseline tax system and arbitrary tax reforms.
We show both theoretically and quantitatively in a calibrated version of our model that the two earnings risk adjustments almost fully oset each other in response to an increase in the progressivity of the tax code. Taken separately these eects are both signi cant, but summing them implies that taxes barely aect the sensitivity of pay to compensation. Moreover, this result is robust to the value of the labor supply elasticity. The fundamental reason is that the sensitivity of the contract to performance is proportional to the marginal disutility of labor.
As a result, in order to elicit a given increase in labor eort, the rm must increase the pass-through of output risk to earnings proportionally to the inverse of the labor supply elasticity. Therefore, if labor eort is relatively inelastic, the change in performance-sensitivity necessary to elicit the optimal eort change must be large, and vice versa. We evaluate the robustness of this result to other canonical tax reforms and show that in all cases, the performance-pay osets at least fty percent, and in some cases even dominates, the direct crowding-out eect. 3 Armed with this tax incidence analysis, we then derive the impact of tax reforms on government revenue and social welfare, as well as the optimal level of tax progres- sivity.
This analysis extends Chetty and Saez (2010) to our environment with arbi- trarily nonlinear taxes. In addition to the standard eects obtained in the benchmark model with exogenous wage risk, the crowding-out and performance-pay eects cre- ate scal externalities: given an initially progressive tax code, a spread (respectively, contraction) of the pre-tax earnings distribution impacts positively (resp., negatively) the government budget. Moreover, the crowding-out eect has a rst-order negative impact on social welfare. This is because, following a tax reform, rms adjust wages in a way that renders tax cuts less accurately targeted than in a model with exoge- nous risk.