Killing conscience: the unintended behavioral consequences of "pay for performance."

• Author: Stout, Lynn A.

1. INTRODUCTION II. OPTIMAL CONTRACTING AND THE IDEOLOGY OF INCENTIVES A. The Meaning of "Incentives" B. The Rise of Incentive Ideology C. Does Incentive Pay Work? Evidence from the Corporate Sector D. Incentives and the Assumption of Selfishness III. UNSELFISH PROSOCIAL BEHAVIOR: A PRIMER A. Lesson 1: Conscience Exists and Most People Know It B. Lesson 2: Social Context and the Jekyll-Hyde Syndrome 1. Instructions from Authority 2. Perceptions of In-Group Membership 3. Beliefs About Others' Prosociality 4. Magnitude of Benefits to Others 5. Conclusion: Understanding the Jekyll-Hyde Syndrome C. Lesson 3: Prosociality and Personal Cost D. Lesson 4: The Role of Character IV. THE UNINTENDED BEHAVIORAL CONSEQUENCES OF PAY FOR PERFORMANCE A. Relational Contracts and Contractual Incompleteness B. Conscience As a Solution to Contractual Incompleteness C. Social Context and Crowding Out D. Conscience, Temptation, and Cognitive Dissonance E. Selection Bias and the Question of Character V. CONCLUSION: ALTERNATIVES TO PAY FOR PERFORMANCE I. INTRODUCTION

   In 2009, the Swiss bank UBS agreed to pay the U.S. government $780,000,000 to settle charges that it had orchestrated a massive scheme to help wealthy Americans evade U.S. tax laws. (1) The UBS case--the largest tax fraud investigation in history (2)--began with the arrest of a single banker named Bradley Birkenfeld. Birkenfeld was one of several UBS employees who had repeatedly helped clients evade U.S. taxes, and he agreed to cooperate with the Justice Department in return for being allowed to plead guilty to a single count of conspiracy to defraud the U.S. government. When the judge who heard Birkenfeld's plea asked him why he had participated in the scheme when he knew he was breaking the law, the 43-year-old banker replied: "I was incentivized to do this business." (3)

   The UBS tax scandal is only one of several recent high-profile cases in which incentive contracts supposedly tempted employees into opportunistic and even illegal behavior. In April of 2013, the nation was treated to the spectacle of dozens of Atlanta public school teachers and educators surrendering themselves to authorities after being indicted for allegedly conspiring to alter student test scores to earn cash bonuses. (4) Incentive pay has been blamed for the savings and loan crisis of the late 1980s (5) and the Enron and Worldcom accounting frauds of the late 1990s. (6) Incentive contracts have also been identified as a root cause of the 2008 credit crisis, when they tempted mortgage brokers into approving loans to unqualified buyers (7) and enticed bank executives into embracing risky investing and lending practices. (8)

   Despite such object lessons, public enthusiasm for pay for performance is still growing. (9) As a Wall Street Journal article put it, "Incentive programs are spreading like ... kudzu." (10) When things go wrong, incentive pay advocates typically argue that the problem lay not in using incentives but in using poorly designed incentives. (11) If we are sufficiently careful in measuring and rewarding individual performance, the "optimal contracting" argument goes, pay for performance schemes harness the forces of greed and self-interest to promote greater efficiency and better economic performance.

   This Article challenges conventional wisdom by arguing that pay for performance strategies, by their very nature, often prove counterproductive and even disastrous "solutions" to complex social problems like corporate scandals and 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 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. 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 this 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.

   This Article does advance two counterintuitive claims. The first is that ex ante incentives 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 suppresses conscience and promotes selfishness for a variety of reasons. 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.

   Part II of this Article begins by describing the optimal contracting approach and its history. It shows how when optimal contracting theorists speak of "incentives," they are not using the word in a broad sense as a synonym for "motivations," as in, "My love for my child gives me incentive to take her to the pediatrician." Rather, they are speaking of predetermined financial or material rewards that are formally negotiated and specified ex ante. Part II shows how the notion that ex ante incentives provide the best, and possibly only, way to channel human behavior--an idea that implicitly assumes people are opportunistic and selfish--has exercised increasing influence in private employment markets and regulatory policy. As an important example, Part II describes the 1993 amendment of the tax code to encourage publicly held companies to use high-powered ex ante incentive schemes to compensate executives. Part II then explores how, despite the enthusiastic embrace of incentive pay by academics, policymakers, and reformers, there is remarkably little empirical evidence to support the claim that incentive contracts actually produce better results, in the business world or elsewhere. Yet rather than question the efficacy of incentive compensation schemes, many experts continue to insist the solution is simply to use more and better ones.

   Part III explores some reasons why incentive pay often backfires. In particular, Part III surveys what behavioral science in general, and experimental gaming in particular, has revealed about the empirical phenomenon of unselfish prosocial behavior (conscience). Contrary to the assumption of opportunistic selfishness that underlies optimal contracting theory, real people often act in an unselfish, prosocial fashion. In lay terms, they act as if they have a conscience that spurs them, at least sometimes, to sacrifice their own material payoffs to help or avoid harming others and to follow ethical rules. While different individuals show different proclivities toward conscientiousness, the data demonstrates that conscience is neither rare nor quirky. Almost anyone other than a clinical psychopath is likely to act unselfishly when certain social cues support unselfishness and the personal cost of acting unselfishly is not too high. Part III uses these findings to propose a simple model of conscience that offers four useful lessons for optimal contracting theory. First, conscience (unselfish prosocial behavior) exists and is a common behavioral phenomenon. Second, conscientious behavior seems triggered primarily by important social cues, especially instructions from authority, perceptions of common group membership, beliefs about others' prosocial behavior, and perceptions of benefits to others. Third, even when the social cues support conscience, it can disappear if the personal cost of acting conscientiously becomes too great. Fourth, individuals vary in their willingness and inclinations toward unselfish prosocial behavior.

   Part IV explores what the findings described in Part III imply about the effects of high-powered incentive schemes. In particular, through at least three different but mutually reinforcing mechanisms, incentive contracts tend to suppress conscience and encourage opportunistic and even illegal behavior that conscience otherwise would keep in check. First, incentive schemes frame social context in a fashion that encourages people to conclude purely selfish behavior is both appropriate and expected. As a result, pay-for-performance rules "crowd out" concern for others' welfare and for ethical rules, making the assumption of selfish opportunism a self-fulfilling prophecy. Second, the...