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Employee stock purchase plans



There has been great interest recently in the use of stock-based compensation in American companies. Although there is an older literature on employee stock ownership plans (ESOPs) and an emerging one on stock options (see Murphy (1999) for a recent review), very little research has been done on employee stock purchase plans (ESPPs). An ESPP See Employee Stock Purchase Plan.  is a tax-subsidized saving vehicle that allows a worker to use after-tax income to purchase company stock, often at a discount. For employees in most plans, the primary tax advantage comes from the fact that if the shares are held long enough, the discount on the stock gets taxed as capital gains rather than as ordinary income. Because many of the tax advantages are contingent upon Adj. 1. contingent upon - determined by conditions or circumstances that follow; "arms sales contingent on the approval of congress"
contingent on, dependant on, dependant upon, dependent on, dependent upon, depending on, contingent
 the plan being offered broadly within a firm, ESPPs potentially represent a much broader vehicle for company stock ownership than stock option plans typically targeted to top executives and key employees. Indeed, the National Center for Employee Ownership (NCEO NCEO National Center for Employee Ownership
NCEO National Center on Educational Outcomes
, 2001a) estimates that over 15 million American workers are eligible for ESPPs.

We make three contributions in this paper. First, we describe the institutional features and parameters associated with ESPP plan design) Second, we describe the corporate and personal income tax treatment of ESPPs, and analyze the circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact.
     2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or
 under which employers and employees will jointly prefer compensation through an ESPP relative to cash from a purely tax perspective. Finally, we examine empirically patterns of ESPP participation and contributions using administrative data from 1997-2001 for a large health services health services Managed care The benefits covered under a health contract  company.

There are two principal findings. First, compensation through a tax-qualified ESPP, the dominant type offered, appears to be less advantageous from a pure tax perspective than through a non-qualified ESPP or cash, unless corporate tax rates are substantially below the top statutory rate and there is substantial share price appreciation. Given that tax-qualified ESPPs are the dominant type of plan, this suggests that non-tax considerations play a significant role in the decision to provide these plans. Second, for most plans, ESPP participation is essentially a risk-free way to increase gross compensation for the employee, yet participation is only about 40 percent at the company we analyze. This suggests that a substantial fraction of employees are either liquidity constrained con·strain  
tr.v. con·strained, con·strain·ing, con·strains
1. To compel by physical, moral, or circumstantial force; oblige: felt constrained to object. See Synonyms at force.

, do not fully understand these plans, or face non-trivial transactions costs.

This paper is organized as follows. The first section lays out the basic institutional features of and facts about ESPPs. The second section discusses the personal and corporate income tax treatment of ESPPs, respectively. In the third section we then analyze the joint impact of personal and corporate taxes on the employer provision of ESPPs. The fourth section provides an empirical analysis of ESPP participation and contributions at a single large firm and considers a number of potential explanations for the substantial non-participation that is observed. There is a brief conclusion.


An ESPP is an employer-sponsored plan that allows employees to purchase company stock with after-tax income. In a typical ESPP plan, employee contributions to the plan are accumulated ac·cu·mu·late  
v. ac·cu·mu·lat·ed, ac·cu·mu·lat·ing, ac·cu·mu·lates

To gather or pile up; amass. See Synonyms at gather.

To mount up; increase.
 by payroll deduction deduction, in logic, form of inference such that the conclusion must be true if the premises are true. For example, if we know that all men have two legs and that John is a man, it is then logical to deduce that John has two legs.  over a six-month offering period. At the end of the offering period, contributions are used to purchase shares of the employer's stock at a 15 percent discount off of the market price of the stock at either the beginning or the end of the offering period, whichever is lower.

Although this is the description of a "typical" ESPP plan, there are many ESPP plan design parameters that vary across firms. For example, although the vast majority of plans accumulate Accumulate

Broker/analyst recommendation that could mean slightly different things depending on the broker/analyst. In general, it means to increase the number of shares of a particular security over the near term, but not to liquidate other parts of the portfolio to buy a security
 employee contributions smoothly over time through payroll deduction, some plans allow employees to purchase shares with cash outright. (2) The period over which this accumulation is done, the offering period, is specified in the company's plan description. Although almost half of companies with ESPPs have a biannual bi·an·nu·al  
1. Happening twice each year; semiannual.

2. Occurring every two years; biennial.

bi·an  (six-month) offering period, this period can be as short a three months or as long as 27 months (the maximum legal time limit for most plans). (3) In all plans, employees are permitted to purchase shares at the end of the offering period. In addition, plans with sufficiently long offering periods may specify intermediate purchase dates. For example, the offering period may be one year, composed of two biannual purchase periods. (4)

A key plan parameter (1) Any value passed to a program by the user or by another program in order to customize the program for a particular purpose. A parameter may be anything; for example, a file name, a coordinate, a range of values, a money amount or a code of some kind.  is the purchase price of the company stock. Although some plans use the fair market value on the purchase date as the purchase price, over three-quarters have what is known as a "look-back" feature, in which the purchase price is the minimum of the fair market value at the beginning and end of the offering period? In addition, the employer may offer the shares at a discount legally limited to be no more than 15 percent applied to the minimum price from the look-back. Naturally, a plan with a discount and a look-back feature can result In a significant gain at sale when stock prices rise during the offering period. The NCEO (2001b) found that 86 percent of ESPP plans offered employees the full 15 percent legal maximum discount on the purchase price of the stock, six percent offered a 10 percent discount, and only eight percent offered no discount. (6)

More complicated ESPPs have a "reset" provision, in which if the stock price falls by the end of the purchase period, the plan automatically withdraws the employees' accumulated payroll deductions for that period, and rolls them into the next offering period. This ensures the lowest purchase price to the employee. Some ESPPs also allow employees with accumulated payroll deductions to individually withdraw those funds before the end of the offering period. Usually when this occurs, the plan stipulates the employee is no longer eligible to purchase in that period, and, in some plans, may have to sit out subsequent offering periods before becoming eligible again. (7)


The tax treatment of ESPPs depends on whether the plan is a qualified or nonqualified plan Nonqualified plan

A retirement plan that does not meet the IRS requirements for favorable tax treatment.
. NCEO (2001b) reported that 77 percent of ESPP plans were qualified. A qualified plan, often referred to as a "423 plan," must comply with the rules spelled out in Section 423 of the Internal Revenue Code The Internal Revenue Code is the body of law that codifies all federal tax laws, including income, estate, gift, excise, alcohol, tobacco, and employment taxes. These laws constitute title 26 of the U.S. Code (26 U.S.C.A. § 1 et seq.  (IRC (Internet Relay Chat) Computer conferencing on the Internet. There are hundreds of IRC channels on numerous subjects that are hosted on IRC servers around the world. After joining a channel, your messages are broadcast to everyone listening to that channel. ). (8) These rules require that only the employees of the company, parent company or subsidiaries may participate in the plan, and the right to buy company stock is non-transferable. However, employees who own five percent or more of voting power (for all classes of stock of the company, parent, and subsidiaries) are not eligible for the plan. At its discretion, the plan may further legally exclude from participation highly-compensated employees as defined in IRC Section 414, employees with less than two years of tenure, and employees who work fewer than twenty hours per week or five months per year? In practice, however, these exclusions do not appear frequently. For example, NCEO (2001b) reported that 98 percent of plans allowed employees with less than two years of service to participate and 68 percent of plans allowed part-time employees to participate.

Beyond these allowable limits on participation, all employees must, in general, have the same rights and privileges under the plan. Section 423 limits ESPP purchases to $25,000 worth of stock (or less) per calendar year, although this will bind for only a small fraction of employees. Plans may limit further the extent of employee participation, such as the number of shares an employee can purchase or the fraction of employee compensation that can be allocated to the ESPP plan, as long as this restriction is applied uniformly across employees. Most plans limit employee contributions to no more than 10 to 15 percent of compensation, and 71 percent of plans impose limits on share purchases (NCEO, 2001a). Non-qualified plans do not have to conform to Verb 1. conform to - satisfy a condition or restriction; "Does this paper meet the requirements for the degree?"
fit, meet

coordinate - be co-ordinated; "These activities coordinate well"
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 these rules and typically are targeted to a select subset A group of commands or functions that do not include all the capabilities of the original specification. Software or hardware components designed for the subset will also work with the original.  of employees, much like non-qualified stock options (NQSOs).

Personal Income Tax Treatment

For a qualified plan (QESPP), the extent of the personal income tax benefit depends on whether the stock is sold in a qualified disposition. A qualified disposition is one that satisfies what is known as the 1-2 holding rule: the employee must hold onto the stock for (1) at least one year after the purchase date and (2) two years after the beginning of the offering period. If this condition is met, the gain at sale is decomposed de·com·pose  
v. de·com·posed, de·com·pos·ing, de·com·pos·es

1. To separate into components or basic elements.

2. To cause to rot.

 into two parts: taxable ordinary income and taxable capital gains. Taxable ordinary income is defined as the lesser of (a) the spread between the fair market value at the time of sale and the purchase price and (b) the discount at the beginning of the offering period. The portion that is taxable as ordinary income is subject to social security (Federal Insurance Contributions Act (FICA FICA
Federal Insurance Contributions Act

Noun 1. FICA - a tax on employees and employers that is used to fund the Social Security system
income tax - a personal tax levied on annual income

)) and unemployment insurance (Federal Unemployment Tax Act (FUTA FUTA Federal Unemployment Tax Act (US) )) taxation as well. The taxable capital gain (or loss) is simply that part of the gain at sale not treated as ordinary income. (10)

Mathematically, we express this as follows. Denote de·note  
tr.v. de·not·ed, de·not·ing, de·notes
1. To mark; indicate: a frown that denoted increasing impatience.

 the fair market values of a share of company stock on the first and last days of the offering period as [P.sub.f] and [P.sub.l], respectively. Let 8 denote the discount off the fair market value, which is legally constrained to be 0 [less than or equal to] [delta] [less than or equal to] 0.15. With a look-back feature, the purchase (exercise) price, [P.sub.e] is

[1] [P.sub.e] = (1 - [delta]) min([P.sub.f], [P.sub.l]).

If the share price falls during the period (and there is no reset provision), the participant purchases at the discounted last-day share price, otherwise the participant does no worse than purchasing at the discounted first-day share price. Let c be the employee's contribution rate made out of after-tax income, but expressed as a fraction of gross earnings y. Then at a purchase price [P.sub.e], the employee will purchase

[2] N = cy/(1 - [delta]) min([P.sub.f], [P.sub.l])


If the shares are sold just when the 1-2 rule is met, denoted as period q, the disposition amount is [P.sub.q]N. The total gain from sale is ([P.sub.q] - [P.sub.e])N, which can be decomposed on a per share basis into two parts:

[3] min([delta][P.sub.f], [P.sub.q] - (1 - [delta])min([P.sub.f], [P.sub.l]))


[4] [P.sub.q] - (1 - [delta])min([P.sub.f], [P.sub.l]) - min([delta][P.sub.f], [P.sub.q] - (1 - [delta])min([P.sub.f], [P.sub.l])).

Equation [3] is the portion of the gain at sale that is taxed as ordinary income, which is the lesser of (a) the spread between the fair market value at the time of sale, [P.sub.q], and the purchase price, [P.sub.e] = (1 - [delta])min([P.sub.f], [P.sub.l]), and (b) the discount at the beginning of the offering period, [delta][P.sub.f]. Equation [4] is the portion of the gain at sale taxed at the long-term capital gains rate.

Participants in a qualified plan may not meet the holding requirements in the 1-2 rule, and, therefore, trigger a disqualifying disposition disqualifying disposition

The sale, gift, or exchange of stock acquired through an employee stock purchase plan within two years of enrollment or one year of the purchase date. A disqualifying disposition results in ordinary income for tax purposes.
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. The spread between the fair market value on the purchase date and the purchase price, [P.sub.l]-[P.sub.e], is treated as cash compensation and is taxed in the calendar year in which the disposition occurs. The difference between the sale price and fair market value at purchase, [P.sub.s]-[P.sub.l], is taxed (offset) as a capital gain (loss) at the appropriate capital gains rate depending upon how long the stock was held. The most common disqualifying disposition is to buy company stock and sell it immediately after purchase, known as a "same-day sale."

For dispositions from a non-qualified plan (NQESPP), the spread between the fair market value on the purchase date and the purchase price, [P.sub.l] - [P.sub.e], is treated as cash compensation and is taxed in the calendar year in which the purchase occurs. (11) The difference between the sale price and the fair market value at purchase, [P.sub.s] - [P.sub.l], is taxed (offset) as a capital gain (loss) at the appropriate capital gains rate depending upon how long the stock was held.

Corporate Tax Treatment

At the corporate level, there is also asymmetric A difference between two opposing modes. It typically refers to a speed disparity. For example, in asymmetric operations, it takes longer to compress and encrypt data than to decompress and decrypt it. Contrast with symmetric. See asymmetric compression and public key cryptography.  tax treatment of QESPPs and NQESPPs. In an NQESPP, the spread between the fair market value on the purchase date and the purchase price, [P.sub.l] - [P.sub.e], is treated as cash compensation on which the firm must pay its statutory portion of the payroll tax Payroll Tax

Tax an employer withholds and/or pays on behalf of their employees based on the wage or salary of the employee. In most countries, including the U.S., both state and federal authorities collect some form of payroll tax.
. The firm deducts the total compensation cost (cash plus payroll tax) in the tax year when the purchase occurred when calculating its corporate income tax. For a disqualifying disposition in a QESPP, the spread between the fair market value on the purchase date and the purchase price, [P.sub.] - [P.sub.e], is treated as cash compensation on which the firm must pay payroll tax. However, the firm deducts the total compensation cost (cash plus payroll tax) in the tax year when the disqualifying disposition occurred when calculating its corporate income tax. For a qualifying disposition in a QESPP, the firm does not get a corporate tax deduction Tax deduction

An expense that a taxpayer is allowed to deduct from taxable income.

tax deduction

See deduction.
, not even for the ordinary income the employee ultimately will claim for the personal income tax.

An Example

Consider a typical QESPP with a 15 percent discount ([delta] = 0.15),look-back and a six-month offering period. Assume the employee is paid $42,500 annually and (on an after-tax basis) contributes five percent of gross pay to purchase stock, or cy = $2,125. Let the share price be $5 on the first day of the offering period ([P.sub.f] = $5) and $8 on the last day of the offering period ([P.sub.l] = $8). With the discount and look-back, the employee gets to purchase at a price, [P.sub.e], of $4.25 ($5.00 x 0.85). The total number of shares purchased with the $2,125 contributed is, thus, N = 500.

Assume first that the employee holds the shares 18 months for a qualified disposition. Let the price at disposition, [P.sub.s], be $15, which implies a disposition of $7,500. The total gain at sale is $7,500-$2,125 = $5,375. The discount at the start of offering period was $0.75 per share ($5.00 x 0.15), or $375 ($0.75 x 500). This is less than the total gain at sale, so $375 is taxed as ordinary income and is subject to FICA and FUTA taxes; the remainder, $5,000 ($5,375-$375), is taxed as a long-term capital gain. Furthermore, because the shares were held for a qualified disposition, the employer gets no corporate tax deduction.

Now assume that the shares were disposed of immediately after purchase in a same-day sale. In this case, the disposition is $4,000 ($8 x 500). The total gain at sale is $4,000-$2,125 = $1,875, all of which is taxed as ordinary income and is subject to FICA and FUTA taxes. Because the shares were sold in a disqualifying disposition, the employer gets a corporate tax deduction for the amount, $1,875, taxed as ordinary income; the employer's statutory FICA and FUTA taxes on the $1,875 are deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes).  as well.


The employer has a choice between offering compensation through cash or an ESPP. To determine which form is preferred, we consider the tax consequences to the employer and employee jointly using the global contracting approach of Scholes et al. (2002). Under this approach, we compare the net benefit to the employee from two forms of compensation that have the same present value after-tax cost to the employer. If one form is tax-preferred by the employee, it will be jointly tax-preferred. Because a QESPP in which all dispositions are disqualifying dis·qual·i·fy  
tr.v. dis·qual·i·fied, dis·qual·i·fy·ing, dis·qual·i·fies
a. To render unqualified or unfit.

b. To declare unqualified or ineligible.

 and an NQESPP are treated effectively the same from the corporate and personal tax perspectives, a useful point of departure is to compare cash to NQESPP compensation. Later we consider the tradeoff between an NQESPP and QESPP explicitly.

Cash vs. NQESPP Compensation

Without loss of generality Without loss of generality (abbreviated to WLOG or WOLOG and less commonly stated as without any loss of generality) is a frequently used expression in mathematics. , we begin by assuming that the employer wants to pay the employee an additional amount of compensation above and beyond current gross earnings y. (12) Second, we note that once the employee purchases shares through an NQESPP, there is no preferential pref·er·en·tial  
1. Of, relating to, or giving advantage or preference: preferential treatment.

 personal capital gains treatment relative to a private purchase by the employee outside of an NQESPP using after-tax cash compensation, and there are no corporate tax implications upon sale. Therefore, the decision to offer an NQESPP hinges Hinges may refer to:
  • Plural form of hinge, a mechanical device that connects two solid objects, allowing a rotation between them.
  • Hinges, a commune of the Pas-de-Calais département, in northern France
 solely on the amount and tax treatment of compensation provided to the employee at the time of purchase, and how it is jointly valued relative to cash. (13)

Specifically, the additional compensation m to the employee who contributes cy to the ESPP is the difference between the fair market value and the exercise price at the time of purchase, [P.sub.l] - [P.sub.e], multiplied by the number of shares purchased, which by [1] and [2] is

[5] m = [[P.sub.l]/(1 - [delta])min([P.sub.f], [P.sub.l]) -1]cy.

Let [[tau].sub.cg] be the marginal tax rate Marginal Tax Rate

The amount of tax paid on an additional dollar of income. As income rises, so does the tax rate.

Many believe this discourages business investment because you are taking away the incentive to work harder.
 on long-term capital gains, [[tau].sub.O] be the marginal tax rate on ordinary income, [[tau].sub.P] be the marginal payroll tax rate, and [[tau].sub.C] the corporate tax rate. In an NQESPP, m is treated as cash compensation on which the firm must pay its statutory portion of the payroll tax, which is deductible, so that the total net compensation cost to the firm on the last day of the offering period is (1 - [[tau].sub.C])(1 + [[tau].sub.P])m. In present value, this is equal to (1 - [[tau].sub.C])(1 + [[tau].sub.P])m[[1 + (1 - [[tau].sub.C])[r.sub.C]].sup.-(l-f)] on the first day of the offering period, where [[tau].sub.C] is the corporate gross rate of return. On a present value after-tax basis, the employer is indifferent INDIFFERENT. To have no bias nor partiality. 7 Conn. 229. A juror, an arbitrator, and a witness, ought to be indifferent, and when they are not so, they may be challenged. See 9 Conn. 42.  to paying m through an NQESPP on the last day and m' in cash compensation on the first day of the offering period, where m' = m[[1 + (1 - [[tau].sub.C])[r.sub.C]].sup.-(l-f)], which would cost the firm (1 - [[tau].sub.C])(1 + [[tau].sub.P])m[[1 + (1 - [[tau].sub.C])[r.sub.C]].sup.-(l-f)] as well.

After payroll and ordinary income taxes, the employee values m' in cash on the first day of the offering period as (1 - [[tau].sub.P] - [[tau].sub.O])m', but values m in deferred compensation on the last day of the offering period as (1 - [[tau].sub.P] - [[tau].sub.O])m[[1 + [rho]].sup.-(l-f), where p is the employee's discount rate. Technically, this discount rate is the sum of the pure rate of time preference from period f to l and the opportunity cost to the employee of foregoing the use of the contribution cy during the offering period. As long as this discount rate exceeds the net corporate rate of return, [rho] > (1 - [[tau].sub.C])[r.sub.C], the employee will prefer the compensation paid in cash.


Recall that the employer does not get a corporate tax deduction for compensation of m paid through a qualifying disposition in a QESPP, but is able to deduct de·duct  
v. de·duct·ed, de·duct·ing, de·ducts

1. To take away (a quantity) from another; subtract.

2. To derive by deduction; deduce.

 m at purchase in a NQESPP. This means that the employer is indifferent between paying compensation of m through a QESPP to m/[(1 + [[tau].sub.P])(1 - [[tau].sub.C])] through an NQESPR For compensation of m in a QESPP, if the shares are sold just when the 1-2 rule is met, then from [2]-[4] the present after-tax value to the employee at q is

[6] [min([delta][P.sub.f], [P.sub.q] - (1 - [delta])min([P.sub.f], [P.sub.l]))/(1 - [delta])min([P.sub.f], [P.sub.l])](1 - [[tau].sub.O] - [[tau].sub.P]) +[[P.sub.q] - (1 - [delta])min([P.sub.f], [P.sub.l]) - min([delta][P.sub.f], [P.sub.q] - (1 - [delta])min([P.sub.f][P.sub.l]))/(1 - [delta])min([P.sub.f], [P.sub.l]) cy](1 - [[tau].sub.cg]).

The first term in square brackets brackets: see punctuation.  is the portion of the gain at sale that is taxed as ordinary income, and the second term in square brackets is the portion of the gain at sale taxed at the long-term capital gains rate. In contrast, for compensation of m/[(1 + [[tau].sub.P])(1 - [[tau].sub.C])] in an NQESPP, if the shares are sold at q, the after-tax value at q to the employee is

[7] [([P.sub.l]/(1 - [delta])min([P.sub.f], [P.sub.l]) -1)(m/(1 + [[tau].sub.P])(1 + [[tau].sub.C])) [[1 + (1 + [[tau].sub.C])[r.sub.C]].sup.(q-l)](1 - [[tau].sub.O] - [[tau].sub.P]) +[([P.sub.q] - [P.sub.l]/(1 - [delta])min([P.sub.f], [P.sub.l]))(m/(1 + [[tau].sub.P])(1 + [[tau].sub.C])) [[1 + (1 + [[tau].sub.C])[r.sub.C]].sup.(q-l)](1 + [[tau].sub.cg]).

The first term in square brackets in [7] is the portion of the gain at sale that is taxed as ordinary income (expressed in period q dollars), and the second term in square brackets is the portion of the gain at sale taxed at the long-term capital gains rate. Therefore, whether the compensation is paid through a QESPP versus an NQESPP depends upon under what values of Ks" vo' [[tau].sub.P], and [[tau].sub.C][6] dominates [7], given [r.sub.C] and a share price path.

There are two clear predictions from [6] and [7]. First, a QESPP should become relatively more desirable as the corporate tax rate falls, because compensation paid through a QESPP is not corporate tax deductible but is through an NQESPP. Second, a QESPP should become relatively more desirable as the spread between the ordinary and long-term gains rates widens, and the employee is able to convert a larger portion of ESPP compensation from ordinary to capital gains income.

Figure 1 shows how the tax advantage of compensation through a QESPP versus an NQESPP (defined as the quotient quotient - The number obtained by dividing one number (the "numerator") by another (the "denominator"). If both numbers are rational then the result will also be rational.  of [6] to [7]) changes with the corporate tax rate, [[tau].sub.c] assuming both a 15 percent discount and a look-back, annual share price appreciation of 10 percent, a profit rate of ten percent, and q - l equal to 18 months (the minimum required holding time for a qualified distribution with a six-month offering period). A tax advantage of greater than one means that the QESPP is preferred to the NQESPP.

As noted above, the tax advantage declines as the corporate tax rate rises, holding other tax rates fixed. Specifically, the solid line gives the tax advantage for an employee with marginal tax rates of 28, 7.65, and 20 percent on ordinary income, payroll, and long-term capital gains, respectively. At the statutory corporate tax rate of 35 percent the tax advantage is 0.89, which implies that the personal tax benefit from the compensation paid through a QESPP is 89 percent of that if paid through an NQESPP. This employee prefers the QESPP only when the corporate tax rate falls below 22 percent. The single-clashed line gives the tax advantage for a high-income employee in the top income tax bracket Noun 1. income tax bracket - a category of taxpayers based on the amount of their income
income bracket, tax bracket

bracket - a category falling within certain defined limits
 and above the OASDI taxable earnings cap, with marginal tax rates of 39.6, 1.45, and 20 percent on ordinary income, payroll, and long-term capital gains, respectively. (14) At the statutory corporate tax rate of 35 percent, the tax advantage is 0.88 in this case. This employee prefers the QESPP only when the corporate tax rate is 20 percent or less. Finally, the double-dashed line gives the tax advantage for a low-income employee with marginal tax rates of 15, 7.65, and 10 percent on ordinary income, payroll, and long-term capital gains, respectively. At the statutory corporate tax rate of 35 percent, the tax advantage is 0.88 in this case. This employee prefers the QESPP only when the corporate tax rate is 21 percent or less.

Figure 2 illustrates how the tax advantage changes as the marginal tax rate on long-term capital gains changes, using the same parameter values as in Figure 1, except the corporate tax rate is fixed at 35 percent. The tax advantage declines as the capital gains rate rises, holding other tax rates fixed. However, the QESPP is never preferred to the NQESPP by any of the employees under this parameterization.

Empirical Implications

This analysis of the influence of taxes on the incentives for employers to provide ESPPs highlights two important issues for empirical analysis. First, QESPPs are offered far more frequently than NQESPPs (77 percent of plans vs. 23 percent as reported by NCEO (2001b)), even though the latter seem to have a greater tax advantage. In contrast, the vast majority of stock option plans, 95 percent, are non-qualified (Hall and Liebman, 2000). Yet for the three prototypical employees illustrated in Figure 1, QESPPs are jointly tax-preferred to NQESPPs only when the corporate tax rate is substantially below the top statutory rate of 35 percent (in the 20-22 percent range, depending upon the employee). Indeed, the assumption of large capital gains associated with 10 percent annual share price appreciation helps to drive the relative attractiveness of QESPPs in the figure. If annual share price appreciation is instead assumed to be 1 percent, then QESPPs dominate NQESPPs only when the corporate tax rate is in the 14-18 percent range (depending on the employee).

This naturally raises the question of why firms even offer QESPPs. One potential explanation is some firms do have both a low marginal corporate tax rate (due to low corporate taxable income) and sufficiently high share price appreciation to make offering a QESPP desirable from a tax perspective. In this regard, NCEO (2001b) reports that the top three industries in 2000 with ESPPs were software, e-commerce, and semiconductor and electronic component manufacturing.

Another explanation is that the non-tax benefits of broad-based employee ownership through qualified plans often cited in the plan administration literature, such as increased loyalty and retention, are sufficiently large In mathematics, the phrase sufficiently large is used in contexts such as:
is true for sufficiently large
 to offset any tax disadvantage relative to a non-qualified plan. We note, however, that there is nothing in principle that prevents the employer from offering an NQESPP that is broad-based and uniform across employees and, thus, mimics a QESPP in design. In practice, there appear to be design differences in the two types of plans. For example, NCEO (2001a) reported that, even though there is nothing that prohibits the employer from doing so, most NQESPPs did not offer a discount on the purchase of company stock, which is common in QESPPs.

The accounting treatment of ESPPs may explain this. Specifically, QESPPs have been deemed as noncompensatory plans for accounting purposes, such that there is no expense recognition at grant, exercise, or sale. However, NQESPPs that provide a discount and are not broad-based may recognize an expense for the amount of the discount (similar to NQSOs granted in the money prior to 2000). This potential non-tax cost of NQESPPs may explain both why NQESPPs typically have not offered discounts and why QESPPs have been the dominant type of plan.

Second, given that the employer has chosen to offer an ESPP, employee participation would be predicted to be 100 percent if all employees were fully informed, financially rational, with access to perfect capital markets and no transactions costs, because contributing to an ESPP and disposing of shares in a same-day sale is essentially a risk-free way to increase gross compensation. To see this, note that the factor in square brackets in [5] is the gross return to the employee on the contribution if the shares are disposed of in a same-day sale. With a 15 percent discount ([delta] = 0.15), which is typical, this return is 17.6 percent even with zero or negative share appreciation during the offering period. For a six-month offering period, this implies an annualized annualized

Of or relating to a variable that has been mathematically converted to a yearly rate. Inflation and interest rates are generally annualized since it is on this basis that these two variables are ordinarily stated and compared.
 rate of return of over 38 percent, far above the annual interest rate charged on credit card debt Credit card debt is an example of unsecured consumer debt, accessed through ISO 7810 plastic credit cards.

Debt results when a client of a credit card company purchases an item or service through the card system.
. Moreover, this is the lower-bound on the potential return to ESPP participation--with a look-back and any positive share appreciation, the actual return can be even greater. Only employees not fully informed or who were unable to borrow would not find participation attractive.


Unfortunately, we do not have data on a large random sample of companies to examine empirically the impact of taxes on the employer provision of ESPPs, and leave that analysis for future research. Instead, in the remainder of the paper, we examine patterns of ESPP participation and contributions using administrative data from 1997-2001 for a large health services company that employs approximately 30,000 people. We use the perfect capital markets, perfectly informed, no transactions cost model as a point of departure for the analysis of employee participation conditional on the firm having decided to offer the plan. Not surprisingly (at least to some readers), we do not find the universal participation in the ESPP plan that this paradigm would suggest. Because of this, we first lay out what employee characteristics are correlated cor·re·late  
v. cor·re·lat·ed, cor·re·lat·ing, cor·re·lates

1. To put or bring into causal, complementary, parallel, or reciprocal relation.

..... Click the link for more information.
 with participation, and then we outline a number of alternative factors that might explain the substantial non-participation.

Company Data Description

The company data come from eight cross-sectional snapshots of all active employees: June and December, 1997; June and December, 1998; June and December, 1999; June, 2000; and December, 2001. The data contain basic administrative items, such as hire date, birth date, race/ethnicity, gender, and gross pay. The data also include variables that capture several important aspects of employee stock purchase plan participation, although we do not have all of this information available for some of the early cross sections. The ESPP data include participation status, the contribution rate, number of shares held, and, for later cross-sections, the number of shares bought and sold. We also have data on 401(k) participation, such as current participation status and an individual's current contribution rate and investment allocation. In addition, we have data on stock options, which are granted to less than 15 percent of the company's employees, at a single point-in-time.

There are four non-wage/savings programs sponsored by this company. The first is the 401(k) plan. This plan is discussed in greater detail in Madrian and Shea (2001). Company stock is not an investment option within the 401(k) plan, and employer matching contributions are not made in the form of company stock.

The second savings plan sponsored by the company is the QESPP. The features of this company's employee stock purchase plan are fairly standard. The plan has two annual offering periods that begin on January I and July I of each calendar year and are six months in duration. Employees can contribute to the plan an integer integer: see number; number theory  percentage of gross earnings up to a maximum of 10 percent through payroll deduction. The plan has both a look-back feature and a discount--the stock purchase price is 15 percent off of the lesser of the fair market price at the beginning and the end of the offering period. All full-time employees are eligible for the plan, as are part-time employees working 20 or more hours per week and temporary employees with assignments lasting more than five months. Beginning in 1999, all employees were immediately eligible to participate upon hire (although they could not actually enroll until the next offering period); before 1999, there was a 60-day service requirement.

The third company--sponsored savings plan is an employee stock ownership plan (ESOP ESOP

See: Employee Stock Ownership Plan


See Employee Stock Ownership Plan (ESOP).
). This plan is not associated with the 401(k) plan and is not voluntary. At year-end, the company allocates a total number of shares, determined annually on the basis of corporate profitability, to the ESOP. These shares are then distributed across employees on the basis of employee compensation (that is, higher paid employees receive proportionately pro·por·tion·ate  
Being in due proportion; proportional.

tr.v. pro·por·tion·at·ed, pro·por·tion·at·ing, pro·por·tion·ates
To make proportionate.
 more shares). Overall, however, the ESOP is small--the mean value of the ESOP accounts is just over $300--and, in fact, the ESOP was discontinued dis·con·tin·ue  
v. dis·con·tin·ued, dis·con·tin·u·ing, dis·con·tin·ues

1. To stop doing or providing (something); end or abandon:
 toward the end of our sample period.

Finally, the company grants stock options to approximately 4,000 of its 30,000 employees. These tend to be the more highly compensated managerial employees within the firm. Unfortunately, we do not have very extensive information on the stock options granted to employees over time, or on when they are exercised. We do, however, have a snapshot (1) A saved copy of memory including the contents of all memory bytes, hardware registers and status indicators. It is periodically taken in order to restore the system in the event of failure.

(2) A saved copy of a file before it is updated.
 of the stock options held by employees at a single point in time.

The sample used for our analysis is all employees who are ESPP eligible, 401(k) eligible, and who have been with the company for at least 1 yean yean  
v. yeaned, yean·ing, yeans

To bear young. Used of sheep and goats.

To give birth to; bear. Used of sheep and goats.
 We impose the tenure restriction because the service requirements for both ESPP and 401(k) eligibility changed during the period covered by our data. Employees with more than one year of tenure, however, were continuously eligible to participate in both plans over the entire time period. Conditional on having one year of tenure, almost 99 percent of employees are eligible for both the ESPP and 401(k) plan. Overall, our sample includes 163,695 person-year observations on 44,943 employees. Table 1 gives summary statistics on the employees in our sample.

One feature of the compensation structure that changed quite significantly over our sample period is the switch to automatic enrollment in the 401(k) plan. Prior to 1998, employees were only enrolled in the 401(k) if they made an affirmative AFFIRMATIVE. Averring a fact to be true; that which is opposed to negative. (q.v.)
     2. It is a general rule of evidence that the affirmative of the issue must be proved. Bull. N. P. 298 ; Peake, Ev. 2.
 election. Beginning April 1,1998, however, all newly hired employees were automatically enrolled in the plan and required to contribute 3 percent of pay unless they actively opted out of participation (a so-called negative election). Madrian and Shea (2001) examined in greater detail the impact of automatic enrollment on 401(k) participation, contribution rates, and investment allocation. While ESPP participation at this company always has been through an affirmative election, the dramatic increase in 401(k) participation from automatic enrollment documented in Madrian and Shea (2001) could have affected ESPP participation if employees viewed the 401(k) and the ESPP as substitute saving vehicles. (15) We discuss this below.

Participation and Contributions: Basic Facts

Table 2 gives summary statistics on ESPP participation and contribution rates for each cross-section. Column (1) shows the sample size of each cross--section. Column (2) illustrates that across all employees, the participation rate, defined as the share of eligible employees having committed to purchase shares in that cross-section's offering period (not as having a positive ESPP share balance) fluctuated between 35 and 38 percent and then rose to almost 44 percent in December, 2001. During this same period, the stock price appreciated significantly. The time path of share prices is shown in Figure 3, along with the S&P 500 for comparison. Column (4) of Table 2 shows that the average contribution rate (conditional on participating) was basically time-invariant, hovering hov·er  
intr.v. hov·ered, hov·er·ing, hov·ers
1. To remain floating, suspended, or fluttering in the air: gulls hovering over the waves.

 around 4.6 percent of pay. Only 7.7 percent of employees (or 20 percent of participants) contributed 10 percent of pay, the plan limit.

Columns (1)-(3) of Table 3 show ESPP participation and contribution rates by various demographic and job characteristics measured in the administrative data: gender, age, race, job tenure and gross pay. The first set of rows in Table 3 shows that ESPP participation is much higher for men than women (47.6 percent vs. 34.8 percent), so that being female is associated with a reduction in participation of 12.8 percentage points. Participation rates are substantially higher for whites than for blacks, Hispanics, or individuals of another or unknown race. In particular, blacks have a participation rate that is 16.5 percentage points lower than that of whites. Finally, the other rows of the table indicate that participation increases monotonically with age, tenure, and income.

We include the tabulations on 401(k) behavior for employees hired prior to automatic enrollment, shown in columns (4)-(6), as an important comparison. In principle, under the perfect capital markets, perfect information, no transactions costs model, 401(k) participation also should be 100 percent and all employees should contribute to the plan limit, because the employees can receive the employer match, cash out, pay the early withdrawal penalty tax, and still come out ahead. This is clearly not the case, as 401(k) participation, though higher than ESPP participation, is also well below 100 percent. As with the ESPP, 401(k) participation is much higher for men and whites and increases with age, tenure, and income. The same observable characteristics that drive ESPP participation also appear to drive 401(k) participation. (16)

Because many of the factors associated with ESPP participation are highly correlated with each other (for example, high-income employees are more likely to also be older, white, male, and high tenured ten·ured  
Having tenure: tenured civil servants; tenured faculty.

Adj. 1. tenured
..... Click the link for more information.
 employees), we next turn to estimating multivariate models to isolate isolate /iso·late/ (i´sah-lat)
1. to separate from others.

2. a group of individuals prevented by geographic, genetic, ecologic, social, or artificial barriers from interbreeding with others of their kind.
 the independent impact of these demographic characteristics on ESPP participation and contributions. The primary dependent variable, [D.sub.c], is a dummy Sham; make-believe; pretended; imitation. Person who serves in place of another, or who serves until the proper person is named or available to take his place (e.g., dummy corporate directors; dummy owners of real estate).  that takes on a value of one if the employee commits at the beginning of the offering period to contribute to the ESPP and purchase company stock at the end of the offering period, and zero otherwise. Let i index individuals, s states, and t offering periods. Then the baseline specification is

[8] [D.sup.c.sub.ist] = [alpha]'[X.sub.ist] + [beta][D.sup.auto.sub.it] + [[gamma].sub.s] + [[theta Theta

A measure of the rate of decline in the value of an option due to the passage of time. Theta can also be referred to as the time decay on the value of an option. If everything is held constant, then the option will lose value as time moves closer to the maturity of the option.
].sub.t] + [u.sub.ist]'

in which X is a vector of variables explaining the participation decision and includes a constant along with dummy variables for the categories of demographic and job characteristics shown in Table 3. The excluded categories are male, age 50 and over, white, job tenure of one to two years, and gross pay less than $20,000. We do not observe marital status marital status,
n the legal standing of a person in regard to his or her marriage state.
 in these data. However, we have the employee's health insurance election: employee-only coverage, employee plus one dependent (a spouse or child), employee plus two dependents (spouse and/or children), or coverage waived. Because individuals who elected employee-only coverage are predominantly pre·dom·i·nant  
1. Having greatest ascendancy, importance, influence, authority, or force. See Synonyms at dominant.

 single, we included a dummy for this health election category in the X vector as a rough control for marital status. We also included a dummy variable This article is not about "dummy variables" as that term is usually understood in mathematics. See free variables and bound variables.

In regression analysis, a dummy variable
 [D.sup.auto] equal to one if the employee was subject to automatic 401(k) enrollment and zero otherwise and a full set of state and offering period fixed effects, [gamma] and [theta], respectively. (17)

Column (1) of Table 4 shows the parameter estimates from the linear probability model The linear probability specification of a binary regression model assumes that, for binary outcome and regressor vector  of ESPP participation. Robust standard errors that account for the fact that there are multiple observations on individuals are reported in parentheses. Women have a statistically significant 0.91 percentage point lower probability of participating in the ESPP. This is, however, substantially smaller in magnitude than the male-female difference of 12.8 percentage points in the unconditional HEIR, UNCONDITIONAL. A term used in the civil law, adopted by the Civil Code of Louisiana. Unconditional heirs are those who inherit without any reservation, or without making an inventory, whether their accep

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