We study optimal compensation in a dynamic framework where the CEO consumes in multiple periods, can undo the contract by privately saving, and can temporarily in‡ate earnings. We obtain a simple closed-form contract that yields clear predictions for how the level and performance sensitivity of pay vary over time and across …rms. The contract can be implemented by escrowing the CEO’s pay into a "Dynamic Incentive Account " that comprises cash and the …rm’s equity. The account features state-dependent rebalancing to ensure its equity proportion is always su ¢ cient to induce e¤ort, and time-dependent vesting to deter short-termism.

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We examine empirically the relation between managerial incentive horizons and several measures of the quality of firms ’ information environments. When a firm’s managerial incentive horizon is short, it is more likely to report income-increasing discretionary accruals and to “walk down ” analysts ’ earnings forecasts; analyst forecast dispersion and absolute forecast errors are greater; and share turnover is greater. These results are consistent with recent theoretical models in which short incentive horizons induce managers to adopt strategies that reduce the quality of their firms ’ information environments and exacerbate information heterogeneity across investors. We also find evidence suggesting that investors at least partly understand these managerial incentives because they attach less credibility to the information in earnings surprises by short-horizon firms.

This paper shows how the stock market’s capacity to aggregate dispersed informa-tion is connected to CEO incentives. In particular, I highlight several informational inefficiencies associated with giving the CEO stock-based compensation and thus discretion when choosing corporate investment. While this scheme leads to high effort provision in equilibrium, it suffers from amplified noise in the stock price and an excessive use of price information (relative to the constrained efficient bench-mark). As a result, stock prices under this compensation mechanism are excessively volatile and exposed to non-fundamental noise. I then compare this incentive struc-ture to a flat wage & fixed investment rule environment in which the firm owners specify an ex ante optimal rule for the CEO. It follows, that the equilibrium out-come demonstrates undistorted price efficiency, but no incentive for the CEO to invest in a profitable growth opportunity. I characterize conditions for the optimal compensation structure and show how a log-linear tax on the firm’s dividend can improve upon the equilibrium outcome.