Slay this Trojan Horse
There’s a huge tax-hike hidden inside a new Senate bill.

By Donald Luskin, chief investment officer for Trend Macrolytics
March 19, 2002, 8:00 a.m.

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.