This paper critically examines the relevance of profit related pay (PR
P) for the U.K. small firm sector. Since 1986, the U.K. government has
actively encouraged PRP, which attracts generous tax breaks, because
it believed that PRP would make pay more flexible downwards and would
significantly improve employee identification, morale and productivity
. An analysis of the theoretical arguments and the assumptions made re
garding the nature of the U.K. small firm sector that underlay these c
laims suggests, however, that the likelihood of achieving either of th
ese alleged benefits is small. An appraisal of the available empirical
evidence on the practical implementation and operation of PRP schemes
suggests that the tax relief simply encourages firms to introduce 'co
smetic' schemes that have no appreciable impact upon the behaviour of
either firms or employees. Moreover, the experience of some firms that
adopted PRP schemes indicates that, far from increasing morale and pr
oductivity, PRP often creates new tensions and conflict between owners
and employees. These and other unintended consequences illustrate the
inherent difficulties of government attempts to use the tax system to
alter the behaviour of agents engaged in a wide variety of complex an
d very heterogeneous bargaining situations.