Employee Share Ownership
More incentives needed

Existing government policies designed to encourage employee share ownership are unlikely to have any lasting effect, Research Fellow Paul Grout told a CEPR lunchtime meeting on 12 February. These policies have encouraged employees to accept shares and options as part of their remuneration, but there is evidence that employees do not remain shareholders in the longer term. In order to achieve this, it may be necessary to discriminate in favour of employee shareholders through tax concessions on dividend payments, Grout argued. Yet it is difficult to predict what effect such policies would have, as to date there has been almost no economic analysis of employee share ownership. Grout outlined plans for a CEPR research study, to be launched in 1986, into the economic consequences of the recent UK policies designed to encourage employee share ownership.

Dr Paul Grout currently teaches at the University of Birmingham, and from April will be Professor of Economics at the University of Bristol. He is also a Research Fellow in the Centre's Applied Economic Theory and Econometrics research programme.

He began his talk by noting the widespread support for employee share ownership in the UK. Although there had been extensive discussion of some specific cases, however, economists had not undertaken any systematic theoretical or empirical analysis of current UK policies. Furthermore, Grout noted, there are many significant economic aspects of employee share and option ownership that have received no attention whatsoever. For example, we know little about how far employees' perceptions of the value of share options reflect the potential market value of those options. This relationship is crucial to the success of option schemes, which form the basis of two of the three main government policies. Anecdotal evidence suggests that employees dramatically underestimate the value of options granted to them by their company. Recent advances by financial economists in the theory of option valuation could be used to clarify this important relationship, according to Grout.

Grout described the objectives of his CEPR research project, to be launched this year. The investigation will explore three aspects of employee share ownership. The first is the impact of the 1978 and 1980 Finance Bill schemes on the wage levels, employment and profits of firms. This will require some theoretical development of appropriate models of firms' behaviour, to provide a framework for detailed case studies, together with econometric analysis of large cross-section data sets.

Share options are the second focus of Grout's research. In order to compare different policies intended to encourage wider share ownership, the implicit value that employees attach to share options must be measured, since their value is not directly observable. Grout's research will draw on recent advances in the theory of option valuation, followed by detailed case studies and analysis of survey data.

Policy evaluation is the third focus for the research. The theory and empirical analyses described above will evaluate current policy as well as new policy prescriptions. A comparative study of employee share ownership policy in the major industrial countries will also be undertaken. A novel feature of this part of the research will be the creation of simulation programmes which are easy to use and which run on widely available microcomputers. Such programmes will allow researchers or policy- makers to incorporate features of a particular policy proposal into the model, in order to simulate its impact on a representative firm and on government revenue.

Grout briefly described the measures contained in the 1978, 1980 and 1984 Finance Acts, noting that each required different theoretical models for analysis. The 1984 Act created an 'effort- incentive' scheme in which options have generally gone to 'key employees' whose performance can directly influence the firm's share value, which in turn has a strong effect on the income of these employees. Schemes introduced under the 1978 and 1980 Acts, however, must be made available to all employees and have therefore resulted in a large number of employees owning a small fraction of the company. A change in the firm's share price will have a much smaller effect on employees' incomes than under the 1984 scheme.

Nevertheless the 1978 and 1980 schemes needed further analysis, Grout argued. Under them not only an employee's job (and hence wages) but also a part of the employee's financial wealth is tied to the uncertain fortunes of the employing company; this increased the overall riskiness of an employee's income and wealth. Employee shareholders of a firm are therefore exposed to a greater 'firm-specific' risk than other shareholders, and economic theory suggests that in the long term employees will reduce their exposure to this risk by selling some of their shares in the firm. There is some evidence that this does occur: after four years employees have sold approximately 20% of shares they have received under the 1978 scheme, despite the fiscal disadvantages of doing so while 75% of their 'lock-in' value is still subject to income tax.

If the government wishes to encourage long-term holding of shares, policy should discriminate in favour of employee shareholders, Grout suggested. This could be achieved by exempting from taxation dividend payments to employee shareholders (up to an annual fixed limit). Under the present imputation system, this would mean that each employee shareholder would receive an annual tax rebate from the Inland Revenue.