By Ed Carberry
Facebook has been in the news recently for receiving a big tax refund. This comes at a time when a never-ending series of manufactured crises have placed the federal deficit at the center of our limited national attention. This comes at a time when Main Street faces dire consequences from the realization of the Norquistian dream of eliminating most sources of tax revenue. Indeed, the news that Mark Zuckerberg and his colleagues at Facebook are receiving a tax refund seems a particularly egregious and confusing manifestation of one of the most significant barriers to recovery: corporations and the wealthy executives who run them seem unwilling to contribute their fair share to get the country moving again.
There are a few problems with a singular focus on Facebook, however. The company is not unique, and they are not using an arcane loophole buried deep in the tax code. Facebook is simply reducing its taxable income through standard accounting practices. Companies can deduct most of the cost of doing business from their taxable income (just like all of us do with our own income taxes), and a significant portion of the cost of doing business for many companies is compensation, including salaries, wages, bonuses, and more complex stock-based mechanisms such as stock options. The latter, which give employees the right (but not the obligation) to purchase a set number of shares at a fixed price, became a significant part of executive compensation in the 1990s. When an executive (or any employee) cashes in their options, there will be a difference between the current market value of the stock and the price at which the employee can purchase it. This is a gain for the employee and deductible as compensation. This gain is similar to a bonus, but a bonus not linked to how many widgets an employee produces an hour, but to an increase in the company’s stock value. Hence, the more executives and employees cash out their options, the higher the value of the company’s tax deduction. In essence, the more companies pay their employees, the more they can deduct. In extreme situations, extremely high compensation can effectively wipe out a firm’s tax liability or provide them with a refund (e.g., Facebook in 2012).
The real issues here are not the tax deductibility of compensation per se or even the level of compensation, but the distribution and actual cost of that compensation to the company. In the case of Facebook, Zuckerberg and other executives cashed out big when the company went public in 2012. However, employees at all levels of the company had stock options and cashed in as well. Facebook is not unique here either: broad-based stock option grants have been part of the Silicon Valley model for decades. At the heart of this model is the belief that employees well beyond the executive ranks drive the value of the organization and should receive a financial stake in its success. This is not to say that Facebook is some type of workplace democracy. Zuckerberg and other top executives likely receive a very large percentage of the stock options at Facebook. However, our attention should be more focused on those companies that are concentrating stock-based compensation in a small group of people. At the heart of this model is the belief that a small group of executives are the ones who drive the value of the company. In most firms, executives make most of their money from receiving company stock, and most employees below the top management level receive no stock at all. Most firms, therefore, receive tax breaks for helping fuel inequality by concentrating the financial returns from economic productivity in a very small group of people. In essence, we are all subsidizing this concentration of wealth.
Should companies be able to deduct the cost of doing business? Yes. Should this include employee compensation? Yes. Should there be unlimited deductions for compensation that is heavily concentrated in a small group of people? Probably not. Should companies be able to deduct unlimited compensation from mechanisms such as stock options, which are much less costly for the company to provide to employees? Probably not. Should these deductions be something discussed in the current debates around the latest fiscal crisis? Absolutely. If we are taking the radical steps of furloughing air traffic controllers, first responders, and other vital public service employees, we should be talking about executive compensation and tax policy. If we are preparing for the inevitable downturn that most economists predict will occur with sequestration and the next manufactured crises, we should be talking about executive compensation and tax policy.
Interestingly, three leading scholars of compensation, in conjunction with the Center for American Progress, have put forward a very simple proposal relating to taxes and stock-based compensation practices like stock options. They call it “inclusive capitalism.” Essentially, the idea is that if a company does not provide stock-based compensation for most of its employees, it cannot deduct any gains that any of its employees receive from this type of compensation, including executives. Sounds like a socialist plot to intervene in the free market? Think again. Health care and retirement benefits currently operate according to the same rules. If a company wants to grant health care to only its executives, that is completely legal. However, if it does so, it cannot deduct that cost from the company’s taxable income. We can do the same exact thing with stock-based compensation. This will either dramatically increase federal tax revenues or propel a more equitable distribution of stock-based pay. This proposal would not have altered the tax refund at Facebook, but it would take away this refund for most publicly traded companies that are granting stock-based compensation to only a small group at the top. This is indicative of a much better approach for dealing with the deficit than the absurd antics that pass for governance in Washington these days.
The deeper issue, however, is that underlying the compensation practices of most large US companies is the deeply held belief that the top executives are the only ones that drive company performance and that they should be rewarded accordingly. Until we begin to see the relative value of the labor of employees at all levels of an organization, we will continue to have a very small group of people receiving the lion’s share of gains of economic production, through cash and stock compensation. Moreover, the companies for whom they work will pay less in tax the more this group receives in compensation.
So, who are the takers in America?