The Effect of Bonus Caps on Workers’ Productivity

This research examined the effect of bonus caps on workers’ productivity, and focused on how low-ability and high-ability workers are affected. Therefore, I extended the model of Lazear (1989) with two different regulations of a bonus cap and compared them to the situation without a bonus cap. In addition, I investigated whether it is beneficial for firms, to increase the workers’ fixed salaries under a binding and non-binding bonus cap restriction. Finally, I studied whether bonus caps are efficient in terms of social welfare. In all cases, I considered both a binding and non-binding limited liability constraint. The results indicate that bonus caps indeed affect workers’ productivity, and lead to lower optimal levels of effort and workers’ utilities. However, a high-ability worker always exerts more effort in the optimum than a low-ability worker, when the bonus is capped at an average maximum percentage of the aggregate fixed salary. Also under such a bonus cap, it is not optimal for the firm to reward different bonus height levels under both a binding and non-binding limited liability constraint. Then, the profit will not be maximized and inequality arises as shown by the exchange mechanism. Besides, it is more beneficial for the firm to increase the fixed salaries under bonus caps, when the price level and the workers’ abilities are higher, and the bonus cap percentage is lower. Finally, bonus caps can distort workers’ contracts and can negatively affect social welfare