Stock Option 'Reform' Would Gouge Taxpayers, Investors, Study Warns

4/16/2002

From: Pete Sepp of the National Taxpayers Union, 703-683-5700

ALEXANDRIA, Va., April 16 -- Legislation masquerading as a post-Enron financial reform conceals a monstrous multi-billion-dollar tax hike that will drain taxpayers and investors, according to a study released today by the 335,000-member National Taxpayers Union (NTU).

"Stock options are increasingly important in giving millions of workers a stake in the success of our economy," said NTU Adjunct Scholar Donald L. Luskin, who is also chief investment officer of Trend Macrolytics, LLC, an independent economics research firm serving institutional investors. "But now a new tax nightmare is emerging to endanger this key component of the American Dream."

Senate Bill 1940, introduced in the U.S. Senate by Carl Levin (D-Mich.) and John McCain (R-Ariz.), is often portrayed as a "corporate sunshine" bill designed to ensure that companies' stock options expenses are duly reported. The bill also limits the amount firms may deduct as a stock option expense from taxable income to the actual amount they report in financial statements. The effect of this change would be to raise billions in taxes, because private sector accounting rules would leave companies with little choice but to take a deduction for options based on the lower "fair value" when they are issued, rather than the higher "intrinsic value" when exercised.

Luskin argues that this provision is unfair, not only because it fails to reflect the true cost to shareholders to honor a company's obligation in providing the options, but also because the "fair value" method relies on speculative modeling rather than market realities. Numerous fiscal and ethical problems result:

-- Using 2001 data, Luskin determined that Cisco's $1.755 billion in tax savings attributed to options expenses were the result of $5.0 billion in actual economic costs that the firm deduced from its income. But using the "fair value" method would permit a deductible option expense of just $1.7 billion, for a smaller tax savings of $592 million -- this amounts to an effective tax hike of 1.16 billion dollars. Oracle would see a $988 million increase under this tax regime, while Sun Microsystems would be soaked for an additional $636 million.

-- Although many large firms in and out of the high-tech sector offer options, S. 1940 would hit hardest the innovative start-up companies, who must issue options because they can't afford to compete for talent with cash compensation. "It's hard to imagine a more punitive tax policy on such a vital sector of our economy, one that could lead us out of a slump," Luskin observed.

-- Because the "fair value" method relies on subjective interpretations rather than facts to arrive at a cost for exercising options, executives would be tempted to jigger such forecasts to produce bigger deductions -- ironically creating, rather than diminishing, incentives for corruption.

-- By tying tax deductions so closely to accounting policies set by the private Financial Accounting Standards Board, Congress would effectively be delegating its power to write tax law. The result would undermine one of the key principles of Constitutional government -- that those who make tax policy should be directly accountable to the voters who pay the bills.

"Disclosure requirements for options expenses are a matter for further debate, but legislating a massive corporate tax increase that would be passed along to workers, investors, and retirees would be a tragic error," Luskin concluded. "S. 1940 is a risky option that Americans cannot afford to exercise."

NTU is a non-partisan citizen organization founded in 1969 to work for lower taxes, less wasteful spending, and accountable government at all levels. Note: NTU Issue Brief 135, The Levin-McCain Stock Option Tax Hike: An Option Americans Can't Afford, is available online at www.ntu.org.