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National Review Online, March 18, 2002
Slay this Trojan Horse
Theres a huge tax-hike hidden inside a new Senate bill.
by Donald L. Luskin
A new bill in the Senate that appears to be about insuring transparency in
the post-Enron world is actually a Trojan horse, filled with an enormous
hidden tax.
Senate bill S.1940, called "Ending the Double Standard for Stock Options
Act," was introduced a month ago by Sen. Carl Levin (D., Mich.), with
co-sponsorship by John McCain (R., Ariz) and three other senators. It seeks
to motivate companies to include executive and employee stock-option
expenses in earnings reports by limiting corporate tax deductions to the
amount that is expensed. But on the inside there's also a tax-hike
structured in a strongly anti-supply-side way that would reduce incentives
to invest and systemically raise the cost of capital for American business.
Tech-industry advocates are fighting the bill today, but they are only
complaining about the hit to earnings calculated using the Generally
Accepted Accounting Principles that would result from having to expense
options and GAAP earnings are just an accounting convention, not real
money. What they aren't talking about is that this is a real tax
increase, one that would cost real money and hurt real
earnings. Here's why.
Today, section 83(h) of the Internal Revenue Code allows companies to deduct
from taxable income the difference between a stock option's exercise price
and the company's stock price at the time the option is exercised. That's
the same basis on which the option holder pays personal income taxes on his
gains. For example, Cisco's current and deferred tax deductions in fiscal
2001 for options exercised on 133 million shares with a weighted average
exercise price of $7.43 was $1.8 billion. It's not specifically disclosed,
but a reasonable guess is that the total expense giving rise to this
deduction was about $5.1 billion.S.1940 would change the Internal Revenue
Code by limiting a company's tax deduction to "the amount the taxpayer has
treated as an expense for the purpose of ascertaining income, profit, or
loss in a report or statement to shareholders. . . . "
On the surface it would seem that all a company would have to do to hang
onto its tax deductions would be to report as an expense whatever amount
they are now deducting. That would be a bad hit to the optics of GAAP
earnings, but the deduction would be preserved and no real money would be
lost. But here's what's inside the Trojan horse: companies can't do that.
They can't just make up GAAP as they go along in order to get tax
deductions. As GAAP is very clear about how options expenses are to be
reported, there's no way under GAAP that companies will get the deductions
they are used to.
Under GAAP there are only two ways to report options expenses. One is the
"intrinsic value method." Because an option issued with its exercise price
set at the current stock price has no intrinsic value, the expense of
issuing it is zero. When it is exercised the company makes no cash outlay,
so that's a zero expense, too. This is the method that virtually all
companies use today in order to justify reporting a zero-options expense.
And zero is not a very attractive tax deduction.
The only permissible alternative under GAAP is the "fair value method."
Under this method a company estimates the value of options when they are
issued using the Black Scholes option-pricing model, and then applies that
value as an expense spread evenly over the option's life.
Returning to Cisco as an example, fiscal 2001 option expenses would have
been $1.7 under the proposed Senate bill. That's a lot less than the actual
economic expense of $5.1 billion, and it gives rise to a commensurately
smaller tax deduction: I estimate that Cisco's deduction would fall from
$1.8 billion to $592 million if this bill were to become law an
effective tax increase of $1.16 billion dollars. And there's nothing
particularly unusual about Cisco most big-technology companies would get
hit the same.
The tax increase is progressive because it gets bigger and bigger as a
company's stock performs better. When a company's stock soars, the real
economic expense of delivering stock to employees who exercise options at
below-market prices also rockets up. Under S.1940, the tax deduction is
fixed forever at the option's fair value at the time it was issued.
The only way out, if S.1940 is enacted, would be for the Financial
Accounting Standards Board to issue new rules that would permit the
inclusion of the intrinsic value of exercised options in income statements.
S.1940 effectively puts the FASB in the position of writing tax law.
That's what's inside the Trojan horse: a huge progressive tax
increase. If S.1940 is enacted, this enormous tax hike would severely
diminish real corporate earnings not just reported GAAP earnings. And the
bigger the expected upside, the bigger the diminution. Companies would move
at the margin to replace option-based compensation with cash compensation,
and real earnings would fall even more. Stock prices would have to fall to
equilibrate with lower earnings expectations. That would have the effect of
raising the cost of capital to companies, which will discourage investment
and risk-taking. And that would lower long-term growth prospects for
the entire economy with those diminished growth prospects requiring even
further downward equilibration of stock prices.
Sen. Levin's bill would hit every company that issues options from
start-ups seeking venture-capital funding to mature technology companies
like Cisco, and all the way up the food chain to giants like General
Electric. But it's the small, young companies at the bottom of the food
chain who will suffer most, because they are most dependent on options for
the acquisition of scarce intellectual capital and they have no other way
to pay for it.
Impairment in that part of the economy would have tragic consequences,
because small companies are the engines of job formation and technology
innovation in the economy. Senators simply can't allow this Trojan horse to
release its dangerous cargo.
Donald L. Luskin is chief investment officer of Trend Macrolytics LLC,
Menlo Park CA.
don@trendmacro.com
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