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deferred equity compensation among U.S. companies. Generally these studies attempt to determine whether agency theory explanations for the use of deferred equity

163 _{Joseph Rich, a compensation specialist with Clark/Bardes Consulting, reported that his} technology clients had shifted CEO equity compensation from 80% options/20% restricted stock in 2001 to 65% options/35% restricted stock in 2002. See McGeehan, supra note 27.

164 _{See Christine Jolls, Stock Repurchases and Incentive Compensation, NBER Working Paper} No. 6467 (March 1998). Jolls does find a significant relationship between executive stock options and share repurchase, which she attributes to executive option holders’ preference for repurchase over dividends. More recent studies suggest that EPS management may be a primary motivation for compensatory option-related repurchase. If dilution drives repurchase, one would expect that restricted stock grants also would lead to share repurchase. Stock grants tend to involve many fewer shares than option grants, however, so this effect may be difficult to discern.

compensation can be supported empirically. But these studies also consider financial constraints, such as liquidity, tax status, and earnings management considerations as potential explanatory variables and thus shed light on the impact of tax status on the use of equity compensation. Again, the evidence is mixed, but the weight of the evidence suggests that loss-making firms do not disproportionately rely on equity compensation.

In a 1995 study David Yermack investigated stock option awards made to CEOs of 792 large (Fortune 500) U.S. companies between 1984 and 1991.165 Among other potentially explanatory variables, Yermack considered corporate liquidity, proxied by payment of dividends, and tax status, proxied by net operating loss carryovers. Yermack found that liquidity was a statistically significant variable. Cash poor firms tend to use options in lieu of cash compensation as expected. Firms with NOL carryovers also were found to be more likely to utilize options, but this relationship was not statistically significant.

Similarly, Matsunaga failed to find a statistically significant relationship between the use of stock options and marginal corporate tax rates.166 Matsunaga’s study examined option grants generally to employees of 123 large companies between 1979 and 1989.

Bryan, Hwang, and Lilien, on the other hand, have found limited support for the proposition that loss-making companies rely more heavily on deferred equity compensation.167 Their 2000 study focused on stock option and restricted stock awards made to CEOs of 1700 S&P 500, S&P mid-cap, and S&P small-cap firms between 1992 and 1997. For the entire sample and for the subset of non-S&P 500 firms, decreasing marginal tax rates helped explain reliance on options in a statistically significant fashion. For S&P 500 firms the sign was right, i.e., reliance on options increased with decreasing marginal tax rates, but the relationship was not statistically significant. The sign was wrong, however, in their restricted stock regressions. Although not statistically significant, restricted stock use tended to increase with increasing marginal tax rates. This study did find statistically significant support for many agency theory predictions related to stock and option awards.168

In an investigation of stock option grants made to non-executive employees, Core and Guay also found evidence suggesting that corporate tax rates affect the use of deferred equity compensation. Examining 1994 through 1997 data, Core and Guay found that firms with positive taxable income and no NOLs relied less heavily on option compensation than other firms.169

Unlike the previous studies, Hall and Liebman have focused specifically on the connection between taxation, both personal and corporate, and the use of stock options.170

165 _{See David Yermack, Do Corporations Award CEO Stock Options Effectively?, 39 J. Fin. Econ.} 237 (1995).

166 _{See Steven R. Matsunaga, The Effects of Financial Reporting Costs on the Use of Employee} Stock Options, 70 Acctg. Rev. 1 (1995).

167 _{See Stephen Bryan et al, CEO Stock-Based Compensation: An Empirical Analysis of} Incentive-Intensity, Relative Mix, and Economic Determinants, 73 J. Bus. 661 (2000).

168 _{For example, firms with abundant investment opportunities and volatile earnings tend to rely} more heavily on CEO stock options while firms with high CEO stock ownership tend to rely less heavily on CEO options. See id. at 663.

169 _{See Core and Guay, supra note 79. See also Patricia M. Dechow et al, Economic} Consequences of Accounting for Stock-Based Compensation, 34 J. Acctg. Res. 1 (1996) (finding correlation between NOLs and use of options in a sample of 4752 firms for fiscal year 1992).

Their study analyzed fifteen years of data from the largest publicly traded U.S. companies. Overall Hall and Liebman concluded that tax rates “have had at most a modest impact on the composition of pay.”171 In their cross-sectional analyses, combined employer and employee tax burdens provided little or no explanatory power.172

V. SYNTHESIS AND REFORM ALTERNATIVES

Now that we have analyzed the economics of equity compensation and reviewed the available empirical evidence concerning employer hedging practices, we are in a position to assess the overall effects of equity compensation and to briefly consider possible tax reforms in light of this analysis. Although taxpayers currently do not appear to be subsidizing equity compensation programs of profitable firms in aggregate, this could quickly change if delta hedging of option grants becomes more common. In addition, the potential for delivering tax advantaged equity compensation raises equity concerns and could undermine the creation of broad-based savings plans. These phenomena could potentially justify alternative approaches to the taxation of equity compensation. In this part we will consider some of the costs and benefits of these alternatives. I conclude that modest reform in the taxation of equity compensation, such as the imposition of a special employee-level tax on equity gains, may be justified.