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Questionable incentives

Tucked away in last week’s federal Budget is a change to the tax code that will curtail use of employee share ownership plans (ESOPs).

Tucked away in last week’s federal Budget is a change to the tax code that will curtail use of employee share ownership plans (ESOPs).

Tucked away in last week’s federal Budget is a change to the tax code that will curtail use of employee share ownership plans (ESOPs). Employees are no longer able to defer the income tax payable on shares they receive from their employer, and only employees earning less than $60,000 a year now receive a $1,000 tax exemption when such tax is paid. The government expects this measure to raise an extra $200 million over the next four years, with much of this new revenue coming from a small number of senior executives who have been deferring their large tax obligations and making a series of complicated transactions to ensure a taxable capital gain instead, which provides for a much lower tax rate.

While the government’s desire to close a loophole is laudable, the opposition fears the demise of ESOPs around Australia. Certainly many employees would have to sell their shares in the same year they receive them to meet the new tax obligations. But support for ESOPs too often rests on flimsy platitudes about ‘aligning incentives’ that do not necessarily stand up to logical scrutiny.

The Australian Employees Ownership Association published a report in 2007 to guide and justify ESOPs for Australian businesses. Such plans apparently ‘provide an incentive for employees to increase productivity and share the rewards of the success of the company’. Yet it cites no empirical evidence.

An employee, no matter how hard he works, is not the primary determinant of his company’s performance, especially if he works for a large public company. Rather, company performance results from the efforts of all employees and the actions of other businesses, which even the directors cannot control. In fact, allocating shares to employees increases the fraction of their income that arises either from luck, or the hard work of other employees! It seems at least possible, then, that ESOPs can reduce productivity of employees by encouraging work behaviour more officious than effective.

In any case, the desire for promotion and the esteem of one’s peers should be sufficient to motivate employees to perform, and unlike the value of any shares granted, success in that regard is determined solely by the employee’s individual performance. Moreover, the additional administrative rigmarole of share ownership is itself expensive and might distract employees from the task at hand.

Indeed, allocating shares to employees can distort their behaviour. If employees view their salary as a retainer — and their shares as some sort of bonus payment ripe for enlargement — then their decisions will tend towards increasing the perceived profitability of their company at a cost to its long-term viability (this should sound familiar). For employees intent on resigning in the next few years, this effect could be especially insidious.

If the logical benefits of ESOPs for company performance are dubious, then what encourages them? A recent survey from academics at the University of Melbourne suggested almost 60 per cent of Australian companies operate some form of ESOP, and most have been implemented since 2000. To be sure, directors might ostensibly disburse small parcels of shares to foster morale among (gullible) staff, but also to entrench their own positions. ESOPs necessarily increase the number of shareholders who would vote emphatically ‘no’ to an external takeover, however worthy that bid might be for existing shareholders. For directors and employees, takeover can spell diminished prestige and pay, and potential unemployment. Directors are no more likely to use ESOPs in the interest of shareholders than they are to agree with a remuneration consultant who recommends a managerial pay cut. Moreover, whatever corporate law might permit, it is unfair that directors can dilute the value of the shareholdings of the existing owners without their express permission.

The popularity of ESOPs must also ignore the financial risk they pose for participants. If an employee’s participation elicits a lower cash salary than would otherwise be paid, then employees endure a riskier financial position: if their employer goes out of business, they lose their jobs and their shares are worthless. Participating employees have put all their eggs in one basket. A higher cash salary would instead allow staff the discretion to invest in other firms whose performance is entirely unrelated to the employee’s own job security.

Notwithstanding the potential for the government’s own inquiries into taxation and executive pay to contradict this reform later this year, removing the ability to defer income tax payments has the potential to change fundamentally how thousands of Australia’s employees are paid. Despite the public commotion, it is far from clear this is detrimental. Indeed, major corporate losses and bankruptcies experienced around the world of late should demonstrate clearly enough that blurring the distinction among ownership, management and employment might be hazardous.

Until it is empirically incontrovertible that ESOPs improve Australia’s economic performance (and it is logically not!), we should not despair that the government is applying greater consistency in the tax code. After all, we have an income tax, and the receipt of valuable shares is certainly income; the burden of proof for exemptions should definitely lie with proponents of employee share ownership schemes.

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