Friday, December 30, 2011

New York Times article on corporate stock options

In today's Times, David Kocieniewski has an article noting how the revival of stock prices has led to a new explosion of executive stock options offering huge payouts to high-ranking executives. The article emphasizes the entity-level tax angle, which is that, when the executives exercise their options - typically at a huge profit, even if their companies have failed to outperform the stock market - the companies get huge deductions that may zero out their taxable income.

The natural reply to make to this critique is that there is no tax angle after all, if the executive is taxed at the same marginal rate as the company. (And note that even a company facing a low average rate on its income, due to other tax planning such as causing its U.S. income from intangibles to be treated as arising in tax havens, may face a 35% marginal rate in the effective range.) Thus, if Steve Ballmer gets a $100 million stock option and both he and Microsoft face 35% marginal rates, then its $35 million tax saving is offset by his $35 million tax bill. Denying it the deduction but taxing the underlying income only once - by allowing him to receive it tax-free - would lead to an identical after-tax result on both sides of the transaction if it responded to the change in rule by paying him $65 million.

I doubt many readers of this blog entry will consider this either a novel or a hugely surprising point. Indeed, it is made repeatedly, and at times vituperatively, by readers of the NY Times article who posted comments discussing it. So let em just add two further lines of discussion here.

First, I would certainly agree that the executive comp discussed in the article is a huge problem, even if it isn't a tax problem. The issues it raises are twofold: distributional and corporate governance. As to the former, rising executive comp over the last 20 years is a huge contributor (both directly and indirectly) to rising U.S. income inequality during this period. Conventional economic theory would suggest that this merely reflects that the execs are adding more value, so even if you dislike the distributional result it would be gratuitously inefficient to attack rising executive comp as such. I happen to think that conventional economic theory is wrong in this case, but that would require a lengthy discussion of its own that doesn't really fit well here.

So let's move on to corporate governance. A large part of the appeal of stock options to inside players as an executive comp tool lies in the opportunity that the options offer to facilitate looting of publicly traded companies, if you want to put it as rudely and crudely as possible. Or. if you want to put it more politely, stock options are a really crucial tool for overpaying mediocre executives - not all of whom can be above-average, after all. Even without any tax angle at all, the options offer a wonderful excuse to compensate the mediocre as if they were geniuses, by allowing them to ride the overall rise in the stock market to claim huge payouts that they pretend reflect their own influence on the stock price. (And if the stock market goes down rather than up, no problem - the company simply reprices the options and gives the executives another chance. So it is rather like getting to place huge bets on the roulette wheel where it's someone else's money, and where if red doesn't come up this time you get to try again and again.)

While this is a serious corporate governance problem, to a degree one could argue that the tax system actually helps, rather than making things worse. High-ranking executives might be happier still if stock options were nondeductible, assuming that this meant that they would also be treated as tax-free to the grantee. Returning to the Ballmer-Microsoft example, in such a state of the world they could announce the value of the grant (at exercise) as only $65 million, yet it would produce the same end result as giving him $100 million under current law.

Indeed, taxpayers like this result so much that they are often apparently quite willing to risk paying MORE tax overall if this permits them to steer as close to it as present law permits. As a starting point for explaining this, note that options could in principle be taxed earlier still - when they are granted, rather than when they are subsequently exercised via a purchase of the company's stock at the option's strike price.

Why aren't executive stock options taxable when granted? After all, they may have significant option value even if they are not yet "in the money." The reason that they usually are not taxable when granted is that they usually remain subject to a "substantial risk of forfeiture" (rather than having irrevocably vested), rationalized on the ground that they represent contingent compensation for future services that might affect the stock price and thus the option value.

Under the relevant Code provision, however, employees can elect to have the options valued and included (as well as deducted by the company) in the year when they are granted. If they make this election, the option is valued as if the risk of forfeiture did not exist.

This in turn led for years to the following tax planning trick. I elect to have my option valued and included / deducted in the year when it's granted. But I claim that the option value is zero, reflecting that it is not yet in the money (i.e., the stock price doesn't yet exceed the exercise price). In fact, the claimed value is ludicrous, since the person claiming the zero value would very likely refuse to sell the option, if this were permissible, even if offered many thousands (or perhaps millions) of dollars for it.

The IRS was so upset about this trick that it issued a regulation providing that, if the option's value isn't sufficiently "ascertainable" (which basically requires that it have an observable market price), taxpayers can't go the election route here. So the IRS effectively forces many taxpayers, contrary to their preferences and an arguably fairer reading of the statute itself before the regulation was issued, to wait for taxable income at a later point.

The funny thing about this, in turn, is that, once the employee has recognized taxable income (and the employer a matching deduction), further appreciation is taxable to the employee (though generally at just the capital gain rate) without a matching employer deduction off any kind. So the low valuation "scam" that taxpayers prefer and the IRS prevents may actually be a route to higher, rather than lower, overall taxation.

What could possibly be going on here? Well, probably several things. For one, if the company has net losses (as may be common in the start-up period even without tax haven games and the like) then the employer deduction doesn't actually make up in full for the employee inclusion. For another, if you hold the stock until death then the deferred tax on post-taxability appreciation permanently disappears. Perhaps a few people are myopic and just want to defer the employee-side day of reckoning. Executives who are trying to hide the ball regarding how much they are actually getting paid don't want to pay tax sooner since it's inconvenient to have to rely on gross-up to make themselves whole.

Bottom line, without condemning today's article in the Times there are still some interesting angles to pursue, though it's possible that the editors would consider them too esoteric for a page 1 placement. But perhaps still worthy of page 1 in the business section?

Tuesday, December 20, 2011

Wonky teaser for my FAT versus FTT article

Bruce Bartlett's newly posted Tax Notes column criticizing financial transactions taxes (FTTs) reminded me that, while James Tobin is often considered the FTT's grandfather due to his 1970s advocacy of a tax on currency exchange transactions, John Maynard Keynes offered a seemingly very similar rationale for a tax on securities trades. However, I may argue in my paper that, insofar as the rationales can be teased apart, Keynes' actually stands up better today than Tobin's.

As the year winds down ..

I'll be spending a significant portion of the winter break writing a short article (based on my talk at the Amsterdam conference earlier this month) called "The Financial Transactions Tax Versus the Financial Activities Tax." I conclude, however, that the article's title states a false opposition, since a financial activities tax (FAT) should be passed in any event, whereas a financial transactions tax (FTT) might or might not be desirable on balance - whether or not there is an FAT - based on issues entirely distinct from the overall treatment of financial sector firms and the risk of another 2008.

Saturday, December 10, 2011

The one time I baffled my Amsterdam audience with American slang

In general, I thought my Amsterdam talk went smoothly and was well-received. But at one point, with reference to bankers who make bets that have positive expected returns for them because they don't bear the downside tail risk, I unthinkingly said something about how sometimes it comes up snake eyes. Alas, pretty much no one in the predominantly Dutch audience knew what this meant, and several asked me afterwards. But they agreed that the Americanism for rolling a pair of ones in craps is striking and apt.

Amsterdam conference on bank taxation

Yesterday was the conference day in Amsterdam at which I delivered my talk on the FTT versus the FAT (see previous entry). The FTT, aka (in an absurd misnomer, whether one Iikes the tax or not) the "Robin Hood tax," did not, for the most part, receive a lot of love. Not surprisingly, representatives of banks and hedge fund-type asset managers were, shall we say, restrained in their enthusiasm for the measure. But academics were mostly skeptical as well, for good reason, notwithstanding the contrarian instincts that a couple of us had.

By the way, although for convenience I'll continue calling the European Commission's proposal an FTT, it is really an STT, or securities transaction tax, as stock trading (other than primary issuance) is the core item covered, and things such as currency exchange (the original Tobin tax target) and debt transactions are excluded.

An FTT is potentially extremely avoidable. For example, as is well known, geographically. A telling example arose when Sweden enacted an FTT a few years back, even though all the financial actors that would have been charged with collecting the tax said they would avoid it by going to London. This of course is a standard taxpayer threat, not always fulfilled in practice, but lo and behold, when the tax was enacted 60 percent to 80 percent (depending which estimate you take) did indeed go to London virtually overnight.

Then of course there is the issue of using derivatives. Why sell stock, for example, if you can use a swap instead. So a modern day FTT is a joke unless it can reach derivative transactions, by interpreting them as versions of some underlying "primary" transaction.

The Commission's response to this problem has been to try to pitch the proposal broadly. While it can't reach transactions that wholly leave the European tax net (e.g., say an American pension fund would have used German bankers to purchase developing world equities, but decides instead to use a U.S. broker), but the design tries to push having some sort of European connection as hard as it can.

Likewise, derivative transactions ostensibly are reached by basing the tax (though at a lower rate than for other transactions) on the highest (in effect) notional principal amount one can come up with in defining the direct transactional equivalent. (Unclear, of course, whether this is coherent or feasible.)

Exceptions for debt and insurance, which are excluded from the reach of the tax, would likely offer fertile tax planning grounds for avoidance efforts, especially if some EU countries decided to compete with each other for the hosting privilege by, say, broadening their state law definitions of insurance.

The Commission's STT would reach a lot of inter-bank transactions (often taxing both sides), and ostensibly would thus apply even to deemed transactions between branches of the same company or corporate group. Indeed, the Commission may regard this as a strength of the proposal, as it ostensibly counters the critique that customers rather than the banks themselves are being taxed. Some pointed out that this sort of cascading tax within the productive process is exactly what the VAT was supposed to end. (And it is of course contrary to any well-informed economic view about how to make business taxation less rather than more inefficient.)

As the next to last speaker on a long day, I was able to modify and fill out my commentary (from the previous blog entry) a bit, such as by noting that what I see as the best case for some sort of an STT (to discourage socially excessive pursuit of zero sum trading gains) would face many of the same problems but require a very different design. I might want to emphasize taxing trades with customers rather than internal cascading, but then again, what is a "customer" for this purpose? Surely it should include people who are seeking trading gains through a business entity (whether via share ownership or compensation arrangements), which potentially brings back the cascading issue. (And, just because integrated businesses, as distinct from those dealing with each other at army's length, are engaged in zero sum battles over division of the surplus, does that mean we want to comparatively tax-favor them? That wholly contradicts the Coase principle of hoping they will pick the arrangements that are best on a pretax basis.) So perhaps I have to settle for an STT just on sales to customers, though including some legal entities such as shells and pension funds, and without here affirming that it would actually be worth doing in the end.

A financial activities tax or FAT on banks, using a VAT-like design but perhaps with rising marginal rates to address bigness, rents, or suspected hidden tail risk (with the choice importantly affecting key design features) seems considerably easier both to design and to rationalize persuasively.

Tuesday, December 06, 2011

Amsterdam slides: The Financial Transactions Tax Versus the Financial Activities Tax

My slides on the FTT versus the FAT, to be presented this Friday at the Amsterdam Centre for Tax Law's conference on taxing the financial sector, are available here.

One topic I don't address in the slides, because I didn't think it was within my topic assignment, concerns the question of FTT feasibility. An FAT is pretty much feasible. The only really troubling question (and I admit it's a significant problem) is defining the set of financial sector firms to which it would apply. In particular, what does one do about the issue of financial firms that are in effect embedded in non-financial firms?

With respect to the FTT, one problem is international considerations, which are likely to be a lot more troubling than those presented by the FAT. Domestic banking activity, which the latter tries to reach, is a more stable and less elusive category than the former's reach of domestic financial transactions (or even those conducted by domestic taxpayers).

But in addition, the wonderful world of derivatives presents a huge challenge for the FTT. I know people are aware of this, and contemplate taxing derivative transactions under the FTT equivalently to the "primary" (or whatever one calls it) transactions that they replicate. But it may often be impossible to determine this equivalence, since there may be multiple renderings of what is equivalent to a given derivative transaction. This is likely to be a big problem even if regulators are able to observe everything that is happening, which is a big question in itself. I believe that other panels at the Amsterdam conference may be directly addressing this issue, but it did not appear to be the focus of the more bigthink-oriented panel on which I was asked to participate. It is certainly important, however.

Part of my responsibility in connection with the proceedings is to write (by the middle of January) a short article that will be published in a conference volume that the Amsterdam Centre for Tax Law is planning. I will of course post it on SSRN, and I also have permission to do something with it in the U.S., such as submitting it to Tax Notes. But I don't know yet if I will consider this suitable. (I'd have to see what I write in order to evaluate this - the issues being both how happy I am with it and whether it seems sufficiently in-context for U.S. publication.)

That photo surfaces again

A number of friends and acquaintances have mentioned to me, over the last couple of days that this 1992 photo of me with (now)-Justice Elena Kagan has surfaced again, this time in the latest issue of New York Magazine.

Someone was kind enough to say that I don't look much different today despite the nearly twenty year interval. But I suppose that, if only the photo were doing all of the aging for both of us, Dorian Gray-style, perhaps I would feel better still. As it is, I can certainly tell the difference between then and now, even if it doesn't all show.

If it's Friday, this must be the Netherlands

Okay, I admit to having overextended myself a bit these past couple of months. But I am hoping my body will accept the last few insults (such as time zone changes and overnight flights) without getting too angry at me.

Although I returned from Brazil only yesterday (Monday, December 5), an evening flight on Wednesday, December 7, will take me to Amsterdam early on Thursday, thus giving me a day to time zone-adjust before I present a talk on Friday at the Amsterdam Centre for Tax Law's Conference on Taxing the Financial Sector. This time, I am just one voice in the crowd, rather than the headliner.

Why did I accept, notwithstanding the events' close proximity? Well, for a few reasons, even apart from my being generally more temperamentally inclined towards yes than no. One is that the conference looks interesting and has a good group of people that is different from those I have been seeing lately at other conferences. Another is that the topic is quite interesting, and different from international tax, which has been my main focus in recent months. Plus, I haven't been in Amsterdam since 1983, and wouldn't mind seeing the Van Gogh Museum and Rijskmuseum again, as well as the Anne Frank House for the first time, not to mention having some rijstaffel and strolling around the canals and all that, even in what is likely to be fairly dismal weather.

The background for the conference is that people in Europe are debating various tax instruments for the financial sector. Unlike in the U.S., such taxes can actually be enacted, at least here and there. The International Monetary Fund Staff advocated a financial activities tax (FAT), which is essentially an excess profits tax on banks (reaching high-end employee compensation as well as profits that remain after paying all that swag). But the European Commission has endorsed a financial transactions tax (FTT) in lieu of the FAT. An FTT is a tax on securities transactions (other than initial stock issuance).

It's unclear to me, even after reading the European Commission's work on the subject, exactly why they prefer the FTT to the FAT. There is probably a political backstory, at which I can guess, but as an American (and thus an outsider to the European debates) I certainly don't know anything about this firsthand.

My own prior work, as well as blog posts, explain why I consider the FAT a better choice than the FTT. But, as my slides will show when I post them here in the next couple of days, I actually do see a decent rationale for enacting a modest FTT in addition to (not instead of) an FAT - or more precisely, independently of whether or not an FAT is enacted. Only, this rationale for an FTT has nothing to do with those offered by the European Commission, or with addressing past or expected future financial sector defalcations, or indeed with responding in any way to the threat of future bank failures reflecting undue risk-taking incentives that are likely to lead in the future either to costly bailouts or to further macroeconomic catastrophes (or perhaps, like last time, to both).

More on this shortly.

Monday, December 05, 2011


Today I flew back from Sao Paulo to engage, among other things, in the grim task of going to the veterinarian in order to assess how my favorite little gal, Ursula, is doing.

The state of the play when I left for Sao Paulo was: Not so good. A couple of years ago, she just barely survived a kidney infection that left her with damaged but still for the most part functioning kidneys. But she had worsened again from a new infection, needing to be hospitalized and placed on IV, which in turn had transitioned to no-heroic-measures. Here is how she looked in the vet's office a few days ago.

So when I went to see her today (with spouse), having pretty much just gotten off the plane from a redeye flight, my understanding was that it was not impossible that we would need to be saying goodbye to her very soon. To my relief, however, she looked pretty good - there is plenty of energy and fight left in the little gal yet, at least for now. So she has returned back home, where she is eating and rubbing her head against people while purring loudly in the accustomed manner. No telling how long this will last, however, and she will be needing daily water shots.

I hope Ursula wouldn't mind if she knew that I was cozying up with some other animals while I was in Sao Paulo. Kind of burying my sorrows, I suppose.

Deborah Paul comments on Avi-Yonah dividend deductibility proposal for corporate integration

Some time back (on October 4 of this year), I was a commentator, along with Deborah Paul of Wachtell, Lipton, Rosen, and Katz, on a paper by Reuven Avi-Yonah of U. Michigan Law School concerning dividend deductibility as a corporate integration method. A link for Reuven's paper is available at my blog entry here, and my comments at the session are available here.

Debbie Paul, whose comments I thought were quite good, has now published a written version on SSRN. It is available here.

Sunday, December 04, 2011

Conference in Sao Paulo, Brazil

I'm in the Sao Paulo airport, awaiting my overnight flight back to the U.S. after a very enjoyable few days here.

My talk, from the PPT slides posted in my previous entry, appeared to go well apart from the obvious distress that I caused the live-simultaneous translators. It took three of them to handle my talk (of perhaps about an hour?). They were dropping like horses on the Pony Express overnight delivery run, and seemed to think I was talking a bit fast. Not the first time I've heard this critique, but the live audience, which was 99 percent listening in English, appeared to be getting it fine. I later observed that quite a few of the Portuguese speakers at the conference, who were likewise being translated live (I believe, just for me), spoke every bit as fast as I do. But the translators told me afterwards (between shudders at the memory of the exhausting experience) that, for every 10 words or so of English speech, you on average need 13 or 14 words to say the same thing in Portuguese.

Anyway, people seemed interested in the talk. Brazil is an interesting case. At one time in the past a territorial country in re. outbound multinational investment, they have gone opposite to much of the rest of the world by shifting to a fairly tough worldwide system, with no deferral, tough formulaic transfer pricing rules, and anti-tax haven rules for foreign tax credit use (cross-crediting). They also have a 34 percent corporate rate, and are asking some of the same questions as people in the U.S. re. what to make of trends elsewhere.

Apparently, their shift in the other direction reflected that the government was looking for tax revenue and acted, whether for better or worse, without a lot of political debate about the usual set of international tax policy issues. But now Brazilian academics and civil society are getting interested, not in a particular change that they've already picked out, but in thinking about the issues more.

I offered the sort of analysis I've been arguing for in international tax policy lately, but without purporting to say "you should definitely do X." Rather, in addition to the structure of the analysis I noted some empirical issues that might help in evaluating what was best.

I also ended up commenting on a couple of other panels, first more on international taxation and then concerning transparency. I also participated in an informal seminar at a very nice separate location (on Ihla Bella, an accurately named island 3-plus hours from Sao Paulo), on issues of how the Internet et al has affected legal issues such as those pertaining to intellectual property. I suppose you could say I took somewhat of a modified Frank Easterbrook "law of the horse" type position.

I can't really say enough about what a warm and hospitable reception I received from the Brazilian and other (such as Argentinian) participants in these various events. I got a cultural impression of greater personal warmth and also taste for having a good time (such as with live music and very late evenings) than one would expect in a get-together of, say, North Americans or Europeans.