The Broadbent Blog

Stock options, inequality, and corporate performance


One of the major forces behind the rapid increase in the income share of the top 1% in the United States and Canada has been rising senior corporate executive pay, especially in the form of stock options. 

The majority of the top 1%, and an even higher proportion of persons in the ultra-wealthy top 0.1%, are either senior managers of non financial companies or work in the financial sector where stock options are usually the biggest single part of total compensation.

Typically, companies give CEOs and senior executives the right to purchase a number of shares at a preset date in the future at a preset price. So long as the share price in the future is above the preset option price, the executive will be in the money and able to purchase shares at below market value on the strike date and cash in the difference.

If the stock price is below the option price, the executive will not exercise the option, and will gain nothing but will lose nothing.

According to Hugh Mackenzie of the Canadian Centre for Policy Alternatives, the top 100 Chief Executive Officers or CEOs of public companies in Canada earned an average of $8.4 Million in 2010, 189 times as much as an average full-time, full-year worker, up from 85 times as much in 1995, and up from “just” 40 times as much back in the 1980s. The pay of top corporate executives below the CEO level has likely increased almost as much.

Mackenzie further reports that 90% of CEOs received some part of their pay in the form of stock options, and that the top 100 Canadian CEOs held a total of at least $2 Billion of “in the money” options at the end of 2010.

One objectionable aspect of paying already well-remunerated executives in the form of stock options on top of their salaries and bonuses is that the gains are not taxed as ordinary wage and salary income, but as if they were capital gains. In other words, just 50% of the windfall from exercising an option is liable to income tax, even though tax experts argue that there is no risk of a loss, but only of a small or no gain.

The employee stock option deduction is a major reason why, as Warren Buffett has repeatedly observed, CEOs often pay lower effective tax rats than their secretaries and other ordinary employees earning a regular wage or salary. An estimated 90% of the benefits of the stock option deduction in Canada go to the top 1% of taxpayers.

And the deduction is a costly one in terms of lost revenue that could be spent on other purposes. According to the Department of Finance, the cost in terms of foregone federal government revenues in 2012 was $785 Million. That would be enough to increase spending on the Working Income Tax Benefit which supplements the income of working poor families by about 70%.

This cost might be considered worthwhile if stock options contributed to a stronger economy and to job creation. But in fact options for senior managers are likely to be causing significant economic damage according to Roger Martin who recently stepped down as dean of the Rotman School of Management at the University of Toronto.

In his 2011 book, Fixing the Game, Martin notes that stock option pay was a negligible component of executive pay until the early 1980s. At that time it was argued by some influential economists that it would be advisable to pay managers based on the performance of the company as measured by the stock price so that the interests of executives would be more closely aligned with those of stock holders.

So far, so good. But Martin argues that stock option pay is the wrong metric for management pay since it is, in many respects, outside of their control. For example, the stock of an oil company will soar if the price of oil soars due to any number of factors or event.

Moreover, stock prices vary widely over time rather than being directly related to profitability or other indicators of company performance. As much as anything else, they reflect the overall state of the economy as filtered though the expectations of markets and the upswings and downswings of speculation.

Even worse, Martin argues, stock options give senior managers a perverse incentive to boost short-term stock performance so that they can be in the money when their options are about to come due. Short-terms expectations which move markets are subject to manipulation.

As a result, stock options generally encourage short-term horizons and game playing with stock market expectations at the expense of boosting long-term corporate performance through major new investments and other determinants of company performance in the real economy.

Martin claims that stock options actually do nothing to boost long-term stock performance, and that we would be better off if senior managers were paid according to metrics over which they do have some control, such as the performance of a company relative to their immediate competition, or market share, or growth of productivity.

In short, stock options have given a big boost to income inequality, make the income tax system much more unfair, and do not have a positive impact on how companies perform. We should, at a minimum, tax gains from options on the same basis as wages. At a maximum we should, as Roger Martin argues, just get rid of them.

Photo: greenjr2. Used under a Creative Commons BY-ND 2.0 licence.