The following post comes to us from Lynn A. Stout, Distinguished Professor of Corporate and Business Law, Clarke Business Law Institute, Cornell Law School and is based on her recent paper, “Killing Conscience: The Unintended Behavioral Consequences of ‘Pay For Performance'” (forthcoming J. Corp. L. (2014)).  The paper is available here.

Contemporary lawmakers and reformers often argue that ex ante incentive contracts providing for large material rewards are the best, and possibly only, way to motivate corporate executives and other employees to serve their firms’ interests. This article offers a critique of the “pay for performance” approach. In particular, it explores why, for a variety of different but mutually-reinforcing reasons, workplaces that rely on ex ante incentive contracts suppress unselfish prosocial behavior (conscience) and promote selfishness and opportunism. The end result may not be more efficient, but more uncooperative, unethical, and illegal employee behavior.

The article challenges conventional wisdom by showing how pay for performance strategies by their very nature often prove counterproductive and even disastrous “solutions” to complex social problems like corporate scandals, rising health care costs, or failing schools. Optimal contracting theory dominates the ongoing debate over executive compensation and is seeping into other policy discussions as well because reformers believe that even when we can’t do much else, we can at least “get the incentives right.” The assumption seems to be that ex ante incentives might help, and can’t possibly hurt. But social science evidence demonstrates that pay for performance schemes can hurt.

Optimal contracting theory relies on a homo economicus model of purely self-interested behavior that predicts that legally enforceable, predetermined material incentives are the best and possibly only tool available to motivate an agent to do what the principal wants the agent to do. This behavioral model, while elegant and powerful, is also dangerously misleading. Extensive empirical evidence demonstrates that when employment contracts are incomplete (as all contracts must be to greater or lesser degrees), employers can get better results by emphasizing “internal” incentives, especially the internal force laymen call conscience.

What’s more, conscience and self-interest often function as substitutes rather than complements.  Ex ante incentive contracts—even well-designed ones—typically create “psychopathogenic” pressures that suppress or snuff out conscience through a variety of mechanisms, including “crowding out,” creating temptations, and inviting adverse selection. The result may not be more efficient agent behavior, but more opportunistic, unethical, and illegal agent behavior.

By showing how incentive contracts suppress conscience, this article does not suggest that pay itself (that is, some form of compensation) is unnecessary. Few employees are willing to work very long or very hard for free. Nor does the article claim that incentive pay is always counterproductive. There may be agency tasks where ex ante incentive contracts perform quite well, despite their negative effects on conscience.

The article does advance two counterintuitive claims. The first is that the sort of ex ante material incentives that optimal contracting theory focuses on are not always the only, or the best, means available for motivating employees. Extensive behavioral evidence demonstrates that with the right combinations of social cues and discretionary ex post rewards, many agents will work harder and more honestly than formal incentive contracts can induce them to. The second point is that for many complex tasks that principals might want agents to perform in the business world and elsewhere, employing ex ante incentives can be dangerous because this strategy for a variety of reasons suppresses conscience and promotes selfishness.

The natural implication of the two points is that instead of relying on ex ante incentives, corporations and other employers often might do better to rely on ex post, trust-based compensation arrangements that recognize both the principal’s and the agent’s capacity to reciprocate prosocial behavior.