Theresa Libby


The incentive effects of fairness: a study of the effect of perceived fairness on budgetary slack and performance

This thesis examines the ability of fair budgeting processes to motivate performance and reduce budgetary slack in two different budgeting settings. The theory of organizational justice is used to define fair budgeting processes. Fair budgeting processes are predicted to lead to improved performance. This thesis goes beyond traditional incentive contracting studies in accounting by considering both outcome-oriented economic incentives and process-oriented incentives that are non-economic in nature.

Results of the two laboratory experiments reported in this thesis indicate that increases in perceived fairness were related to increased performance and decreased slack creation. In the first study, a fair process was defined as the ability of the subordinate to voice an opinion about the budget suggested by the superior and the receipt of an explanation for the budget that the superior finally sets. Subjects were asked to voice an opinion about the budget to be set, but subjects' opinions did not influence the budget assigned to them. Those subjects who also received an explanation for the budget that was set judged the budgeting process to be significantly fairer and were significantly more productive than those who had a voice but received no explanation. These results imply that voice is important to individuals' fairness judgments and their performance in budgeting settings but, in situations where voice does not result in influence over budget that is set, the receipt of an explanation plays the most significant role.

In the second study, subjects acting as subordinates had private information regarding their own productive capability. Subordinates were compensated under either a truth-inducing or slack-inducing incentive contract and were exposed to budgeting environments characterized as fair, unfair, or neutral. Performance was measured as the amount of budgetary slack created by subordinates in these three environments. For subjects who had a more negative attitude toward risk, the slack-inducing incentive contract combined with a fair budgeting environment was as good at reducing the amount of slack created as the truth-inducing contract. A fair budgeting environment also led to reduced amounts of slack for subjects who had a less negative attitude toward risk and were compensated under the truth-inducing contract. These results imply that understanding a manager's degree of risk aversion may be key to selecting between slack-inducing and truth-inducing incentive contract forms and, most importantly, the use of budgeting processes that are perceived to be fair leads to a reduction in slack above and beyond the reduction achieved by the incentive contract alone.