Andrew Stumpff, an employee benefits law professor at the University of Michigan Law School and the University of Alabama Law School, along with Norman Stein, a Douglas Arant Professor of Law at the University of Alabama Law School, have recently written a piece for Tax Notes’s Shelf Project entitled – “Repeal Tax Incentives for ESOPs.” The article appears in the October 19, 2009 issue of Tax Notes. Professor Stein is a sought after advisor to the Congress on retirement savings policy, and is highly respected by staff policy makers in the Administration and the key Congressional tax committees.

 

Tax Notes’s Shelf Project is a collaboration among tax professionals to develop proposals to help Congress raise revenue without raising tax rates.

 

While a close read of the article reveals more of a dislike, or debunking if you will, of the economic theories of ESOP originator Louis O. Kelso, its bottom line is ESOPs do not improve company performance, do not increase wealth consistently, and therefore do not deserve to be ERISA plans nor have tax benefits.

 

According to their particular proposal, all qualified retirement plan would have to be well-diversified investments. Meaning that ESOPs would and should be subject to diversification rules and all ESOPs tax incentives should be repealed because as the authors state, “ESOPs represent bad public retirement policy…”

 

They provide four reasons for changing the tax policy to repeal ESOP tax incentives: (1.) ESOPs are not necessary to, and do not, increase workers’ wealth; (2.) Stock ownership does not improve worker productivity; (3.) The pain of underdiversification; and (4.) No reason to subsidize ESOPs.

 

None of the arguments are new. We’ve heard them all and sometimes, even more interesting ones. But we thought we’d take a deeper look into the reasons cited and provide our own analysis.

 

The idea that ESOPs do not increase the wealth of workers. The authors state that even workers without large amounts of capital are still able to make a living by working. But what about retirement?  “Wow, I wish I could work until the day I die,” is not a statement one hears often or ever for that matter. Almost everyone tries to plan for retirement and ESOPs allow individuals that do not have access to large amounts of cash to invest in something that can help him/her prepare for retirement.   The average account balance among ESOP Association members is $64,652.06 which is on par with the average 401(k) account average in the U.S. In addition, ESOP Association members report the average contribution the company makes to the ESOP each year, as a percentage of covered compensation, is 13% which is much higher than the 2 – 4% average one finds with 401(k) plans.

 

The idea that stock ownership does not increase worker productivity.  We’re going to cite research and let is speak for itself.  

 The idea that underdiversification causes pain. The authors state that “ESOPs are a terrible idea because they concentrate employees’ retirement finds in a single investment.” ESOP advocates respond that the worship of diversity is somewhat misplaced when applied to those of little wealth. Diversification arose in English common law as a policy for someone of wealth, or for a beneficiary of a wealth trust. To diversify a little bit make no sense for someone who has no wealth. All great wealth is created by someone focusing his/her attention on one economic activity. Mellon, Carnegie, Rockefeller, etc. did not become wealthy by putting $1,000 in steel, $1,000 in autos, $1,000 in oil, $1,000 in lumber, etc. In any event, the 1986 tax law mandated diversifying ESOP accounts up to 50% for those nearing retirement at age 55 and 10 years of service. Furthermore, evidence is overwhelming that ESOP companies are more likely to provide retirement plans, such as diversified 401(k) plans than non-ESOP companies. It must be remembered that 50% or so of American workers have no retirement plans where they work so the argument that underdiversifaction causes pain is truly a moot point.

 

Finally, the idea that ESOPs should not subsidized. The criticism arises from a view that the income tax system should be “neutral,” with no special rules to encourage an activity. These special rules, either tax exclusions, credits, deductions, or deferrals, are known as “tax expenditures.” The theory is that only a minority of taxpayers, or citizens, benefit from a tax expenditure while other taxpayers subsidize the few with high tax rates. It is estimated that the special tax rules for ESOPs amount to approximately a $1.7 to $2.0 billion tax expenditure for ESOPs annually. So the argument goes, ESOP tax expenditures benefit 11 million individual taxpayers out of approximately 200 million tax payers, and 12,000 corporations out of 4 million. At this level of effort, ESOPs are approximately the 149^th largest Federal tax expenditure among approximately 165. (The precise numbers are not available because Congress and the Executive Branch have always disagreed over revenue estimates and definitions involving tax expenditures.) The amount is approximately less than .0005% of the national $15 trillion economy. The amount is approximately sixty one-hundredths of 1% of the annual Federal budget in the next fiscal year. To say elimination of ESOPs will lower taxes for tax payers not participating in an ESOP and for businesses without ESOPs for liability because they no longer subsidize the ESOP community, is actually a ridiculous proposition.

 

There is much more that we can discuss but we’ve covered the major points here.

 

Thoughts?