Performance Evaluation and Corporate Income Taxes in a Sequential Delegation Setting

Abstract

We consider a setting where a firm delegates an investment decision and, subsequently, a sales decision to a privately informed manager. For both decisions corporate income taxes have real effects. We show that compensating the manager based on pre-tax residual income can ensure after-tax NPV-maximization (“goal congruence”) for each decision problem in isolation. However, this metric fails if both decisions are nontrivial, since it requires asset-specific hurdle rates and hence precludes asset aggregation. After-tax residual income metrics (e.g., EVA) allow the firm to consistently apply its after-tax cost of capital as the hurdle rate to its aggregate asset base. We show that existing tax depreciation schedules may explain why firms in practice use more accelerated depreciation schedules than those suggested by previous studies. Our findings also rationalize the widespread use of “dirty surplus” accounting for windfall gains and losses for managerial retention purposes.