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?
Organizations and Social Change 
On the point of who creates value, and who gets to collect it: a piece in the NYT today http://www.nytimes.com/2013/03/19/business/questions-for-public-private-pact-that-led-to-xeljanz.html highlights how Pfizer is charging over $2000 a month for an arthritis drug developed with (partial) public funding! So when NIH (that’s us, the public) acts as the entrepreneur, the senior execs still appropriate the value!
Thanks, everyone for your excellent comments! Just a few responses.
David, I think you rightly highlight one of the core problems here, i.e., the belief that lower level employees do not really play a role in value creation. I disagree somewhat with Andy Psallidas that “their value to the company is lower than the value of top executives, and this is why the top executives will continue to receive more in compensation until something changes dramatically.” Certainly in many cases, the skills and experience that executives bring to organizations are more valuable than people in middle and lower positions. However, the current system has swung way too far the other way in assuming that people below the executive level do not actually matter much. Corporations are collective enterprises. Ask executives at Google who drives the value of the company. Ask the executives of most firms on the 100 Best Places to Work who drives the value of the company. The answers will be “everyone.” The experience of Intel and its brain drain nicely illustrate this point. The question is not whether executives should be compensated well for what they bring to the table, but why should so much of the economic returns of production go to them and what are the consequences? The money that gets paid to executive does not get reinvested into growing the firm, it does not get used to hire more employees or to provide better benefits for the other (less valuable) employees. In other words, the decisions that create executive compensation packages are choices, not the simple outcome of the magic of a free market for executive labor rewarding those with the appropriate skills. Markets are shaped by actors, who occupy different positions of power within organizations and the corporate governance system. As the work of Lucian Bebchuk and Jesse Fried has argued persuasively (1), CEOs exert significant power over how their compensation is set. In fact, in a recent meta-analysis of studies assessing this theory of managerial power (2), two Dutch colleagues and I find strong evidence in support of it. I think it is time we take a closer look at how the structure of the corporate governance systems influences the distribution of the economic value of the firm, and whether we think this is the most productive and equitable distribution in terms of which people drive value creation.
With regards to Andy and Eliad’s points about the motivating potential of employee stock ownership, the academic research presents a complex picture. Simply providing people with stock does not in and of itself motivate employees, nor is motivation a linear function of the amount of stock that employees receive. The research is pretty clear, however, that broad-based employee ownership has positive effects on employee outcomes such as motivation and job satisfaction, as well as corporate performance, when it is combined with increased employee participation in job-level decision-making, shared information about firm performance, and job security (3). In other words, employee ownership makes a difference when companies value employees as capable of helping to run the business, as playing a key role in value creation. Many of these companies could be paying their executives more, but they instead have invested some of this money back into their employees
References
1. http://www.pay-without-performance.com/
2. http://www.academia.edu/2586155/Assessing_Managerial_Power_Theory_A_Meta-Analytic_Approach_to_Understanding_the_Determinants_of_CEO_Compensation.
3.http://www.academia.edu/2571392/Employee_Ownership_and_Shared_Capitalism_New_Directions_in_Research
Great post, Ed! another problem with high compensation through stock options is the powerful incentive for distorting earnings and even fraud to boost stock prices. This was an important factor in the 1990s bubble then dot com crash after 2000, and a repeat cycle leading up to the crash of 2008. But Ed alludes to a deeper problem at the end of his post, the ideological conviction that only the top execs “create value”, or for entrepreneurs, “create companies and jobs”. Yes, entrepreneurs have creative energy, but successful organizations are collective endeavors, with numerous workers at every level contributing to value creation. We know all too well that top management continues to award themselves high bonuses even when performance is poor – because they can. Stock option awards can therefore be seen as mechanism of value appropriation by powerful actors in the value chain.
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The topic of taxes and employee compensation is fascinating, and a lot of talks will be concerned with it in the future. In his conclusion Dr. Carberry argues that companies need to begin to see the relative value of the labor of employees at all levels of an organization, and not just at the top level.
Even several investors advocate firm practices of paying in stock, because they want employees to share their pain when their stocks are not doing well. But lower level employees do not affect company’s performance to the same degrees as top level executives do.
Despite the fact that stock ownership would seem to give employees a reason to work harder and better than ever before, it has other effects which negate this owner mentality. When employees have much of their net worth tied up in a company’s stock price, it’s often detrimental to the long-term interests of large investors. Many option-heavy Silicon Valley firms face significant brain drains when their stocks do well; their employees can afford to retire. The problem becomes even worse when a company’s stock stops rising (as all stocks inevitably do, because eventually a company’s growth prospects get priced in).
A great example was Intel, the premium semiconductor maker, experienced a 17 percent increase in employee turnover in 2004 when its stock stagnated after almost doubling in 2003. It’s no coincidence that after this brain drain the company struggled and two years later had to lay off 10 percent of its employees as its results sagged.
So even though it does not seem fair to lower level employees, their value to the company is lower than the value of top executives, and this is why the top executives will continue to receive more in compensation until something changes dramatically.
It might be that Facebook was picked on because the company is a market leader, but a closer look will reveal that we are talking about real numbers and more than just the idea of tax refund. According to Blumberg Business Technology, Facebook reported 1.1 billion dollars in pretax revenue. Not only will Facebook not pay taxes, it will receive a $429 million tax refund.
A note about Stock Based Compensation:
The effectiveness of Stock based Compensation depends on how much of your salary is the compensation, the bigger it is the more likely you are to work towards increasing the company’s revenue. Many companies encourage their employees to work harder towards this goal by giving them a bonus which is based on the number of hours they work.
But there is always the risk that some employees don’t work as hard but still receive the same compensation.
Should the goverment intervene in cases like this? I guess that it depends on what side of the map you are. But we need to keep in mind that it doesn’t have to be “all or nothing.” There might need to be a cap on the amount the companies can deduct.
Source:
http://www.businessweek.com/articles/2013-02-15/facebook-gets-a-multi-billion-dollar-tax-break
For a copy of the Center for American Progress report, see:
Click to access worker_productivity.pdf
Dr. Carberry’s comments are backed up by a wide variety of studies. I believe, however, that the argument can go one step further — not only would the proposal have the impact he describes (increasing federal tax revenue, broadening wealth, or both), it would also be likely to make American companies more competitive. Research on companies with employee stock ownership plans (ESOPs) indicate that broadly shared ownership increases company profitability, longevity, and tendency to create and retain jobs.
This is a very thoughtful analysis, Ed. At least in the case of Facebook and similar entrepreneurial companies the founders who created the business are getting the huge amounts of pay. At most established public companies, it is the top executives, especially the CEOs, getting enough to buy small countries even though their average tenure is only five years and often their outsized rewards have little or nothing do do with value they actually created.