Document Type

Article

Publication Date

3-22-2004

Abstract

Over the last two decades, the use of company stock and options thereon to compensate and motivate employees has become widespread. Defenders of stock-based compensation argue that it creates value for shareholders because it encourages employees to work harder and with a common purpose. Critics, however, are less sure and stock-based compensation has come under heavy attack from investors, commentators and academics. Critics argue that it imposes excessive risk on employees and overstates net income. To date, there has been very little detailed legal or economic analysis of the tax efficiency of stock-based compensation. What serious work there has been has generally concluded that such mechanisms are inefficient, perhaps highly inefficient. Clearly, given the heavy use of stock-based compensation and thus the substantial tax costs firms would incur if it were tax inefficient, measuring the tax saving or cost from stock-based compensation is an important gap in the debate over the wisdom of its heavy use. In this paper, I define tax efficiency and develop a methodology for assessing whether a compensation mechanism is tax efficient. I then apply that methodology to various forms of stock-based compensation. I show that there is no general answer to the question whether stock-based compensation mechanisms are efficient. Instead, I show that the tax efficiency of such mechanisms depends upon several factors, including tax rates, what investment (if any) the grant displaces, and how the displaced investment would have been held. As a result, the efficiency of stock-based compensation can vary across employers and even across employees of the same employer. Accordingly, I cabin the efficiency cost of stock-based compensation over a wide range of circumstances and show that under reasonable assumptions stock-based compensation can produce a joint net tax benefit to employer and employee.

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