Question

You are about to start working at car dealership that is currently reporting losses due to flooding but will be profitable in a few years. Assume you’re your risk adverse and your supervisor cannot fully monitor your actions. The key metrics at this dealership include both financial data (number of sales, margin on sales) as well as qualitative data (survey of experience). You are tasked with designing a compensation contract.

1. Define in your own terms moral hazard and adverse-selection Describe how the firm may want to establish a compensation contract for you given moral hazard and adverse selection issues.

2. Does this change depending on your level of risk aversion?

3. Discuss both tax and nontax factors from both the employee and employers perspective.

4. Suppose a firm has a tax loss in the current period of $200, which when added to prior tax losses gives it an NOL carryforward of $300. The top statutory tax rate is 21%. Assume an after-tax discount rate of 10% and future taxable income of $50 per year. What is the firm’s marginal explicit tax rate?

5. Create the compensation contract with points 1-4 in mind. Keep this contract to a single page. You will be graded on creativity, presentation, and writing clarity.

Answer 1

ANSWER :

A compensation agreement will  include information regarding all parties involved in the discussion of the contract ,it will include details of how compensation of employee will be on basis on job description.The compensation must include details of salary,salary components and commission bonus details if any.

The contract needs to mention all details regarding the type of compensation like daily wages weekly wages or monthly salary.So next would be to define commission and bonus details if any.

It will include details of Terms of employment whether contractual or permanent.Then details of holidays need to be described.Policies relating to moral hazards,bereavement etc.

A)

The moral hazard in above case be the risk that employee will bear for joining the firm where risk is born by the employee and cost by employer.The adverse selection can be to minimise risk by way of insurance if loss happens in the future.

The employee is taking risk by joining company which is in losses due to flooding ,where he can ask for insurance for covering risk of loss of compensation if company does not perform well in future.

An employer can do following for reducing moral hazards

1) Make a policy for compensation to minimise moral hazards

2)Design incentive plans for the employees.

3)Defining path of advancement for employees to help them excel professionally.

B.)

Yes this will change will level of risk aversion.More aversion to risk ,less acceptance to risk level so higher is risk higher is premium or incentive for the employer.

C).

Tax factors for employer can be

1)Annual Tax obligations like tax payable on income.

2)compensation packages.

3)Restructuring business by changing capital structure

4)Tax aspects on liquidation

Non tax factors

1)Business expansion and subsidies.

2)asset protection under government policies

Tax factors for employee

1)Tax payable for salary

2)for rewards and compensation

3)Professional taxes and tax deduction at source

Non tax factors

1)In case of funds distribution and investments.

D.)

Marginal explicit tax rate=change in Tax/change in taxable income

=21-10/50

=11/50*100

=22%

E.)

Employment Agreement for Position of Sales manager in XYZ delearship

Date

To

Mr XYZ

Address

It is my pleasure to to extend offer of employment at XYZ dealership.

Title of Job: Sales Manager

Job description:As attached

Employment Terms:

a)Commencement of employment.

b)Relieving for 2 months prior notice from either side.

Compensation

1)Basic Pay

2)Incentives for moral hazards.

3)Bonus

4)Salary advances

Leave details:this will include details of government holidays,vacations and yearly leaves.

Retirement benefits,health ,welfare,group insurance details

• After an employee completes a probationary period or finishes an annual review to create any changes in wage structure.
• Raises or bonuses
• Amendments to non-monetary compensation forms, such as personal or vacation days