A cut of the action, or the unkindest cut? Since Budget night, commentators have been debating the merits of employee share ownership programs (ESOPs), and whether their current tax-preferred status is too generous. But with interest groups dominating the discussion, surprisingly little attention has been paid to the economic evidence. Would Australia be better off if we raised our current level of employee share ownership (6 per cent) to that of the US (19 per cent)?
There are two reasons economists typically worry about ESOPs. First, they expose workers to additional risk: when Enron collapsed, its employees lost not only their jobs, but also a large portion of their retirement savings, held in the form of company stock. Second, economists have had a tricky time understanding why employees in a moderately large firm should work harder because they get a fixed share of the profits.
But recent findings from Harvard economist Richard Freeman and co-authors suggest that economists should be comfortable with ESOPs. In a series of papers, they present evidence that modest holdings of company shares (less than 10 per cent of an individual’s portfolio) do not expose people to undue levels of risk. Firms with ESOPs also seem to have less turnover and enjoy greater loyalty from their staff.
All well and good, but what do ESOPs do for the bottom line? In a one-worker firm, we might expect ESOPs to have large impacts. Adam Smith famously extolled the productivity benefits of the 18th century French sharecropping system, under which landowners provided farmers with seed, cattle and equipment, and then landowner and farmer split the profits at the end of the season.
But the incentives weaken as the firm grows. Suppose your 100-person firm decides to introduce an ESOP. The next day, you must decide whether to work harder. If you do, then part of the gain goes to capital, and of the labour share, you get 1/100th. You know that Lazy Joe who works alongside you isn’t going to pick up the pace, but he’ll still benefit from your extra sweat. In this scenario, standard economic theories struggle to explain why ESOPs should have any effect on productivity.
Yet they do have an effect. Drawing together studies from the US and the UK (where the Treasury recently completed a major impact assessment (PDF 175KB) of ESOPs), Freeman shows that productivity is higher in firms that have ESOPs. And workers gain too - wages and training are higher in companies with ESOPs than in those without. Moreover, it does not appear that workers are merely trading off salary for shares: in studies that have looked at the transition to such a plan, salaries continue to rise at about the same rate as in other firms in the same industry.
The reason that ESOPs succeed appears to be because they reduce shirking. In US surveys, most say that they have seen a fellow employee “not working as hard or well as he or she should over an extended time period”. But despite observing shirkers, many do not bother to say anything to their co-worker or a manager.
ESOPs can change this. Having a stake in the firm makes workers more likely to speak out when they feel that a colleague is not pulling his or her weight. This is easier to reconcile with the 100-person puzzle, since the cost of an occasional chat with a shirker is plausibly pretty low.
Freeman’s research also indicates that it isn’t just ESOPs that deliver these gains: similar impacts are observed from other high-powered incentives, such as profit-sharing and individual bonuses. Moreover, such “shared capitalist” incentives seem to operate best in conjunction with plenty of on-the-job training, employee involvement teams, and limited managerial supervision. For workers to effectively monitor each other, management has to take a step back.
Although much of the research is based on cross-sectional correlations, it seems to indicate that ESOPs are good for firms and workers. Does that mean it’s thumbs-up for a tax break?
Not so fast. One of the notable features of Freeman’s work is the emphasis on firm culture. Referring to the current Australian debate, he told me: “I have been struck in the UK data and at least in US stories that when firms choose ESOPs or related profit-sharing schemes, the ones that do so for reasons beyond the tax incentives tend to do better. If all the firm wants is a tax break it may not change its ‘culture’ and benefit from worker participation.”
Put another way, aligning workers’ incentives with a firm’s bottom line can induce higher productivity. But it doesn’t follow that generous government incentives will transform the managerial style of a corporation. ESOP tax breaks may be money better spent elsewhere.
Discuss in our Forums
See what other readers are saying about this article!
Click here to read & post comments.
6 posts so far.