Market Symmetry and the Tax Efficiency of Equity Compensation

Abstract

At first blush, the deferral of employee income recognition associated with equity compensation appears to provide a tax advantage in a rising market but an offsetting disadvantage in a declining market. Merton Miller and Myron Scholes argued, however, that this apparent symmetry is misleading and that employees can hedge to ensure tax efficiency despite market uncertainty. This article demonstrates that the effect of employee hedging is fairly small, but that a combination of factors, including capital loss limitations, the possibility of employee-favorable ex post adjustments to equity compensation arrangements, and employee hedging, do cause compensatory stock grants and nonqualified options to be tax advantaged on an expected value basis.

Keywords: stock options, restricted stock, equity compensation, global tax advantage

JEL Classification: H22, K34, M52