ESOP Sops Up Taxes to Little Effect

There’s something intuitively appealing about ESOPs--employee stock ownership plans. They’re a sort of workers’ capitalism. The idea is that workers become shareholders in their own company. They’re then more committed to its success. Conflicts between workers and managers fade. Cooperation flourishes. The company becomes more productive and profitable. Workers get rich. Society prospers.

The trouble is that ESOPs don’t actually operate this way. Perhaps 200 major companies have adopted them in the past year. Procter & Gamble is among the latest. But don’t expect a surge of worker involvement or improved corporate efficiency. The infatuation with ESOPs is strictly expedient. They provide generous corporate tax savings and offer top executives a new defense against hostile takeovers.

Suppose you’re one of Procter & Gamble’s 77,000 workers. The company will contribute $1 billion in stock to its own ESOP. The stock will be allocated to workers’ individual ESOP accounts over 15 years. That’s an average of almost $900 per employee a year. Do you come to work earlier? Go home later? Suppose you detest your supervisor. Do the two of you now turn into fast friends?

“People aren’t (experimental) rats,” says Joseph Blasi, author of “Employee Ownership, Revolution or Rip-off?” and a management professor at Cal Poly San Luis Obispo. “They do not respond automatically to modest financial incentives.” Studies of ESOPs confirm this conclusion. The plans’ rewards are too small and too distant to change how workers work. Most know that individually they can’t raise their firm’s profits or stock price. Profitability and productivity improve only if the ESOPs are part of a broader program to engage workers and involve them in everyday decisions.

Nor do the plans give workers something for nothing. An ESOP is a fringe benefit. Companies can typically spend only so much for salaries and fringes. Spending more on one benefit means spending less on something else, as economist Michael Conte of the University of New Orleans points out. Sometimes the shift is invisible. But many companies have explicitly cut other benefits when creating ESOPs.

The Treasury estimates that ESOPs will cost the federal government more than $3 billion in lost revenues over the next five years. This estimate--made before the recent ESOP boom--may prove far too low. To promote ESOPs, Congress has granted them many tax breaks. A company creating an ESOP usually borrows (say, from a bank) to buy its own common stock or to finance an issue of new stock. The stock goes into the ESOP, triggering these tax benefits:

--The company can deduct both interest and repayment of the loan’s principal from taxable income. Normally, only interest is deductible.

--The lender (in this case, the bank) doesn’t have to pay taxes on half the interest income from ESOP loans. Some of the tax savings are passed onto the borrower. Consequently, ESOP loans have interest rates 1 to 1.5 percentage points lower than normal business loans.

--The company creating the ESOP generally gets a deduction for stock dividends paid to the plan. Dividends aren’t usually tax deductible.

But these tax breaks didn’t start corporate America’s ESOP stampede. What did was the demonstration--by Polaroid--that ESOPs could be used as a takeover defense. Creating an ESOP places a big block of stock in friendly hands. Employees are less likely to sell their shares, because they fear new owners might fire workers. An ESOP can act as a powerful takeover deterrent in states with tough anti-takeover laws.

Consider Delaware, where about half of all major U.S. companies are chartered. The Delaware anti-takeover law requires a hostile buyer to get 85% of a company’s stock before being able to exercise effective control. Thus, many new ESOPs tie up about 15% of a firm’s stock.

There have been ESOP successes. In 1984, Weirton Steel Corp. in West Virginia was spared bankruptcy through an ESOP. But the workers also took a 20% pay cut, and the real spur to better cooperation was the threat to jobs. A few stirring stories don’t justify a huge tax break.

The ESOP was once touted as a way to transfer corporate wealth to workers. But the rise of pension funds has already accomplished significant redistribution. In 1950, pensions owned stocks equal to less than 1% of the stocks owned directly by households. In 1988, pensions owned $758 billion of stock, equal to one-third of household stock wealth. ESOPs contributed almost nothing to this process.

ESOPs are a growing waste of taxpayer money. They may foster corporate inefficiency by sheltering mediocre managements. Getting workers and managers to cooperate is important, but tax breaks for ESOPs can’t achieve that. Employee stock ownership and profit-sharing can succeed as a part of a wider corporate commitment to a collaborative style of management. That’s a commitment that companies and workers must make themselves. It can’t be imposed from Washington.