We examine the effect of contract framing on subordinates’ propensity to create budgetary slack and subsequent performance. The contract is designed in economically equivalent penalty and bonus forms, with a reporting bonus (penalty) associated with reporting budgeted production accurately and a production bonus (penalty) associated with beating (not meeting) a budget target. By design, this contract creates a direct link between the budgeting component and the effort (performance) component. In such a setting, the effects of contract framing may lead to different behavioral responses than previously examined or predicted. We find that under bonus-framed contracts individuals create budgetary slack by underreporting their productive capabilities. Consistent with prospect theory, we find evidence that subordinates working under penalty-framed contracts over-report their capabilities. This reporting of optimistic slack is an interesting finding. The results suggest that under penalty-framed contracts subordinates are more likely to over-report their capabilities, whereas subordinates under bonus-framed contracts are more likely to under-report their capabilities. The findings demonstrate that penalty contracts impact how individuals report their capabilities, suggesting that penalty contracts may be more advantageous than bonus contracts in some settings.