The Effect of Compensation Caps on Risk-Taking

Abstract

Using an experiment, we investigate the joint effects of compensation caps and formal justification requirements on risk-taking. Compensation caps restrict the earnings potential of decision-makers and have been implemented to influence risk-taking behavior, especially after the financial crisis. Rational choice theory predicts that caps should restrict only risk-seeking decision-makers from taking undesired risk and not affect risk-averse decision-makers. Based on the compromise effect, however, we predict that compensation caps will also affect risk-averse decision-makers. Moreover, we posit that the effect of compensation caps on risk-averse decision-makers is stronger in the presence of high justification pressure. Our results support both hypotheses and indicate that compensation caps have unintended consequences. In particular, risk-averse decision-makers also take less risk when their compensation is capped, especially in combination with justification requirements, which are another frequently used instrument to steer risk-taking. The result might be dysfunctionally low levels of risk-taking for exploiting entrepreneurial opportunities.

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