A Theory of Participative Budgeting

This paper complements the ongoing empirical discussion surrounding participative budgeting by comparing its economic merits relative to a top-down budgeting alternative. In both budgeting regimes, private information is communicated vertically between a principal and a manager. We show that top-down budgeting incurs fewer agency costs than bottom-up budgeting whenever the level of information asymmetry is relatively low. Although the choice between top-down and bottom-up budgeting ultimately determines who receives private information within the firm, we find that both the principal and manager's preferences over the allocation of private information remain qualitatively similar across the two budgeting paradigms. Specifically, while the principal always prefers either minimal or maximal private information, the manager prefers an interim or maximal level of private information regardless of who is privately informed. Last, we use our model to address empirical inconsistencies relating the firm's choice of budgeting process, the resulting budgetary slack, and performance.