The Economics of ESOPs--Posner's Comment

I share Becker's concerns with the favorable tax treatment of employee stock ownership plans. Such treatment would be justifiable only if such plans conferred benefits on society that could not be generated more cheaply by other means. Proponents of the law that authorized ESOPs and conferred favorable tax treatment on them argued that ESOPs would unlock a new source of capital—namely workers, who contribute capital to the corporations that employ them when they take part of their compensation in the form of participation in an ESOP. But there is no shortage of capital, so no justification for subsidizing investment in corporate stock. If anything, ESOPs can be criticized from an overall social-welfare standpoint as an antitakeover device that we do not need: workers are unlikely to vote for a takeover, as it might jeopardize their jobs. As Becker points out, abolishing the favorable tax treatment of ESOPs would permit a market test of this form of corporate governance. (In confining my discussion to cases of governance, I focus on situations in which, as in United Air Lines before its bankruptcy, or the proposed reorganization of the Tribune Company, the ESOP owns all or a controlling amount of the common stock of the corporation.) I believe that it would usually flunk the market test. Granted, the ESOP has an advantage over the conventional worker-owned firm: the value of a firm's capital stock is the discounted present value of its expected future earnings, so that a worker who owns ESOP shares has, at least in his role as part owner, the same horizon as the corporation itself, rather than the truncated horizon of the worker in a conventional worker-controlled firm (a cooperative), who cannot benefit from anything the corporation does after he retires and who consequently has no financial stake in maximizing the corporation's present value. But this advantage of the ESOP over the conventional worker-controlled form will usually be modest. A worker will trade off any long-term benefits to the corporation from a corporate action that would increase the value of his shares against whatever short-term benefits, in the form of a higher salary or greater fringe benefits or a lighter workload, an alternative course of action would confer on him; and usually the tradeoff will favor increased compensation for work over increased stock value. It is true that to be entitled to the tax benefits of the ESOP form, the workers' shares must be placed in trust, and the trustee must vote them to maximize share value; he cannot trade a lower share value for higher employee compensation of the worker owners. (And so he cannot oppose a takeover that would maximize share value, even if it would do so by laying off many of the workers.) If the favorable tax treatment of ESOPs were abolished, there would be no requirement of placing ESOP shares in trust. But that would still be an attractive choice for the ESOP in order to reduce the misalignment of incentives in conventional worker-controlled firms. But overcoming the problem of incentive incompatibility would not create an affirmative reason for a worker to own shares in the corporation that he happens to work for rather than in some other corporation, a mutual fund, etc. Becker rightly rejects the notion that having an ownership interest closely aligns a worker's incentives with those of the corporation. Unless the corporation is very small, which obviously is not the case with United Air Lines or the Tribune Company, the efforts of an individual worker will not have a significant effect on the market price of the corporation's shares and hence on the worker's wealth. Of course, some workers may not realize this (they may exaggerate the contribution that their working harder would make to the firm's bottom line); or they may, by virtue of being "owners," become altruistic toward "their" company; but such workers would be likely to buy shares in the company voluntarily (or take part of their compensation in the form of shares), without all the workers having to do so. The ESOP has one genuine advantage over the conventional corporate form, an advantage that played a role in the decision to convert the ownership of United Air Lines to an ESOP. It can smooth labor relations by increasing the cost to workers of striking or otherwise pressuring the corporation to incur greater labor costs. Even though, as I have suggested, workers' work-compensation gains will usually exceed the losses in share value that will result from the corporation's greater labor costs, their demands will be moderated by the cost to them in lower share value. This depends however on the shares being held in trust, so that the workers' interest as workers is not reflected in how the shares are voted; otherwise workers may use control of management to increase rather than moderate their demands for employee compensation. But as I have said, the trust format could be retained even if it were no longer required. Against the possible (tax-independent) advantages of the ESOP form stands the powerful disadvantage of underdiversification. The shares in their employer's ESOP are likely to be the principal financial asset of the workers. If they are risk averse, they will be bearing uncompensated risk by holding an underdiversified portfolio. The consequences were dramatically demonstrated by the United Air Lines bankruptcy. The trustee was sued for not having sold United stock before the collapse, but because the purpose of an ESOP is to hold stock in one company, namely the employer of the participants in the ESOP, an ESOP trustee does not have the usual trustee's duty of diversification; what exactly his duty is to protect the participants against excessive risk is unclear. A further complication is presented by employee turnover. An employee who quits and goes to work for some other employer cannot remain a participant in his former employer's ESOP. His shares must be redeemed—but at what price? If the ESOP owns all the common stock in the employer, the fixing of a redemption value will be awkward. If it is too low, this will reduce the value of the shares to other employees who anticipate quitting at some future time; if too high, it will reduce the value of the shares by diminishing the corporation's assets, out of which the price to redeem departing employees' shares is paid. Still another complication is reconciling the competing interests of different classes of ESOP shareholder, such as active and retired employees. To summarize, were it not for the favorable tax treatment of ESOPs, one would not expect the device to be common except in small corporations (and perhaps not even there, since the partnership and the closely held corporation provide attractive alternative governance forms) and in some firms that have particularly troubled labor relations.

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