APPENDIX Tax Implications of Qualified Stock Options
How do taxes affect the relative attractiveness of receiving compensation in the form of wages versus qualified stock options, given U.S. tax law? Consider first the treatment of wage payments. A dollar of pretax corporate income paid out as wages results in a net cost to the firm of (1 -τ) and net income to the employee of (1 -t). Per dollar of net cost to the firm, the employee receives (1 - t)/(1 - τ).
What changes if instead the employee receives a dollar of pretax corporate income in the form of qualified options? If the firm transfers a dollar’s worth of options to the employee, as valued by the market, the cost to the firm is simply a dollar—the firm is not allowed any tax deductions as a result of this form of compensation.
What is the after-tax value of this transfer to the employee? If the employee faced the same future tax obligations on the options as he would have had he simply purchased the option directly, then the employee would value the options at a dollar. Assume as a simple example that the exercise price on each option is the initial share price, share prices increase at rate c without uncertainty, and options must be exercised within T years. If he purchased an option directly, and the current share price is 1, then the value P of the option must satisfy
where g is the capital gains tax rate and d is the individual’s discount rale. When he later sells the resulting shares, his basis will be ecT.
If instead he receives the option as compensation, he again will exercise the option at date T but under U.S. law he owes no taxes at that point. However, his basis when he later sells the shares will be 1 rather than ecT- Assume this later sale takes place in year T+n when his capital gains tax rate is gn. Then, relative to purchasing the options directly, he initially saves
When the firm pays the employee a dollar’s worth of options, using equation (Al) it is easy to see that the value of the compensation to the employee equals
If g is small enough that the second and third terms in equation (A2) can be ignored, then the gain from receiving a dollar of compensation in qualified stock options rather than wages equals
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)| false Gordon, Roger H., and 1995, “Why is There Corporate Taxation in a Small Open Economy? The Role of Transfer Pricing and Income Shifting,” in The Effects of Taxation on Multinational Corporations, ed. by ( Martin S. Feldsteinand James R. Hines Jr., Chicago: University of Chicago Press).
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Roger Gordon is Reuben Kempf Professor of Economics, University of Michigan. This paper was written while the author was visiting the IMF’s Fiscal Affairs Department. He very much thanks the IMF for its support of this research.
Similarly, when new approaches fail, other firms will know not to make the same mistakes.
While patents help strengthen the incentives to try new technologies, patents cover only a fraction of the economic innovations that occur. Even in these cases, the resulting incentives understate the social return to an innovation, given the benefits to consumers from the innovation.
In the United States, for example, the 1950s and 1960s were a period of particularly high growth rates, yet top personal tax rates during this period were as high as 87 percent.
This income shifting may or may not generate taxable capital gains income at some point in the future. Under the U.S. personal tax code, capital gains are exempt if they remain unrealized at death, and a number of other countries exempt all capital gains from tax. See, for example, Holland (1969) for an earlier discussion of the gain from setting up a new firm to convert ordinary income into capital gains.
For example, other employees must take into account the possibility that the firm is offering them equity as compensation in part because the equity is overvalued.
This pattern of tax rates of course does not always prevail. An exception, for example, would be the U.S. rate structure between 1987 and 1992.
The relative effects on entrepreneurial activity versus copycat firms and tax shelters will depend on more detailed aspects of the tax code, however.
Under U.S. law, if the shares are held until death as the evidence in Bhatia (1970) suggests is the norm, then the capital gains are never taxed under the personal tax. For a detailed examination of the tax implications of wage compensation versus compensation through qualified stock options, see the Appendix.
Until recently, corporate accounting income would also be higher. Owing to Statement of Financial Accounting Standards (SFAS) 123, however, U.S. firms must now report a deduction when they pay executives using qualified stock options.
There are also, of course, mechanisms for receiving compensation in a form deductible under the corporate tax yet not taxable under the personal income tax (e.g., “fringe benefits“), and also for receiving deferred compensation.
When the firm has outside owners, the employees can instead be paid in the form of shares of equity in the firm. Under U.S. tax law, they would be taxed (and the firm would receive a deduction) equal to the “fair market” value of these shares. In practice, this would likely be approximated by the book value, which can be very small compared with the market value, particularly in new firms where the value depends almost entirely on future prospects.
An explicit calculation of the tax incentives is found in the Appendix.
Those with income levels between these two figures had an incentive to shift income into the corporate tax base until their marginal corporate tax rate jumped above their personal tax rate, assuming they cannot easily set up multiple corporations. The main jump in the corporate tax rate occurred at $50,000 of corporate income.
If employees switch from qualified stock options to some form of deferred compensation (e.g., nonqualified stock options), the change in reported corporate and personal incomes will show up only several years after the initial tax change, when the deferred compensation is finally paid out.
The corporate profit rate increased, however, in 1993 according to preliminary data, as would be expected given the jump that year in the top personal tax rate.
These loans result in a further shift of taxable income from the individual to the firm due to the resulting interest deductions for the individual and interest income for the firm.
Since the employee would want to postpone selling the equity received each year from the firm, this adjustment needs to take into account the risky return on all holdings of equity in the firm and not just on those shares issued most recently.
The efficiency gain depends on the resulting increase in the employee’s effort and the implied gain to outside shareholders from the extra effort. If there is an upper limit on the amount of the employee’s effort, the marginal gains must eventually asymptote to zero.
Employees involved with the production of intangible assets (e.g., managerial ideas or product designs of uncertain value) would also have a marginal product that is difficult to measure other than through equity values.
When the shares are publicly traded, the employee knows the current market price. However, asymmetric information is still very much an issue since the firm should have information the market does not about the firm’s true value, suggesting that it knows whether the equity price will tend to rise or fall over time as the market gradually infers this information.
If it can restrict this offer arbitrarily to a subset of the employees, then a separating equilibrium may be possible, that is, a firm with a higher value of є can offer a lower value of s to a smaller fraction of its employees. For simplicity, assume that all otherwise identical employees must receive the same offer, and so focus on a pooling equilibrium. The key qualitative properties of such a separating equilibrium are the same as those of the pooling equilibrium focused on here.
A sufficient condition for this is that є has a uniform distribution. The righthand side equals zero when є* is at its lower bound. Similarly, when є* = ∞, then є= 0 and the right-hand side is infinite. Therefore, the right-hand side is increasing on average over the range of є*. However, in general, it may not be a monotonic function of є*, for example, it drops discretely at any mass point in the distribution of є.
The U.S. tax does allow loss carrybacks for up to three years and loss carryforwards for up to 15 years. Auerbach and Altshuler make a convincing case, however, that these provisions do not closely approximate full loss offset.
Since 1986, the U.S. tax law has prevented “passive losses” from being deducted from other income sources. Losses experienced by someone actively running a business remain deductible, however.
In the United States, choices can be changed midyear, but cannot be changed again for five years. Since firms commonly have a string of years with tax losses initially, and taxable profits later, this restriction should not be that binding.
If there are nontax advantages to pursuing a new project through a new firm, for example, there is no need to force changes on an existing organization and no need to spend time convincing many other managers in a large firm about the value of the project, then the tax law imposes a tax distortion discouraging individuals in low tax brackets from pursuing ideas for productive projects.
If the law is to discourage copycat projects while encouraging entrepreneurial projects, then it should have a locally convex rate structure over the range of returns relevant for a copycat project, yet have a sufficiently concave rate structure over the broader range relevant for an entrepreneurial project that the entrepreneurial project gains on net.
Copycat projects, being less risky, require less time from a manager to set up. Once they are set up and running smoothly, the manager is likely to want to sell out and use his skills to set up yet another venture. In contrast, entrepreneurial projects, which explore much more uncertain ideas, will likely demand many more years of a manager’s skills to reach maturity. As a result, managers of copycat firms are likely to realize their capital gains more quickly than owners of entrepreneurial firms. To this extent, a higher capital gains tax rate can also be used to discourage copycat firms relative to entrepreneurial firms.
When the definition of taxable income differs from economic income, activities that generate tax losses will be favored by the tax law and would likely be owned in noncorporate form by individuals in top tax brackets, whereas activities generating taxable profits will be discouraged by the tax law and will either be corporate or operated in noncorporate form by individuals in low tax brackets. The same considerations apply to any activities generating nonzero taxable income that consider changing organizational form to take advantage of tax rate differences. See Gordon and MacKie-Mason (1994) for further discussion.
Firms that are in a position to borrow heavily against their fixed capital would be in the best position to shift earnings across time periods to take advantage of changing tax rates over time. See, for example, Gordon, Hines, and Summers (1987) for further discussion.
For early evidence of such a pattern of returns, and an explicit recognition of the tax explanation, see Kahn (1964).
The problems arising from asymmetric information would be less with debt finance, so that models that ignore bankruptcy costs (e.g., Myers and Majluf, 1984) forecast debt rather than equity finance. Consistent with the dominant role of venture capitalists, assume that this advantage of debt is more than outweighed by the resulting agency and bankruptcy costs.
To the extent that employees of large firms can engage in income shifting, the tax rate here would be reduced to reflect the gains from income shifting when employed by a large firm.
Assume though that his personal savings are sufficient to cover his own living expenses even if he earns no cash income during the start-up years.
If instead te< τ, then a new firm will choose to be noncorporate throughout its life.
If the entrepreneur is to have enough funds to cover these expenses, it must be that
If the corporate income tax is nonlinear, then A (1 - τ) would be replaced by the after-corporate tax earnings.
Presumably, the fraction s will be limited by the need to provide the entrepreneur sufficient incentives to undertake the project successfully.
Potential entrepreneurs with te<e* can still negotiate with a large existing firm to undertake the proposed project, but then face the added nontax costs, D.
These tax rates can also affect the amount of resources invested in trying to forecast price changes in the equity of existing firms.
This is the approach taken to measuring the efficiency consequences of tax distortions used, for example, in Gordon and MacKie-Mason (1994).
Risk-free projects that enter simply to take advantage of the differential tax rates yield no obvious externalities.
The possibility of excessive activity, given asymmetric information, was made also in de Meza and Webb (1987).