Deferred Stock Awards: Good For Risk, Bad For Tax Revenue

It seems that deferred stock bonuses are all the rage on Wall Street these days. Goldman Sachs, for example, recently came out with a plan to provide its top employees with stock bonuses that are locked up for five years. Other banks are considering similar strategies, in an attempt to silence the public's criticism of the short-term incentive nature of their bonus structures. While many are applauding this approach from a risk standpoint, there's sure to be one party that can't be thrilled -- the government.

When I try to think of the clearest example of someone who doesn't hate Wall Street, one stands out: the governor of New York. After all, Wall Street is responsible for an incredibly large portion of the state's annual income tax revenue. Without the financial sector in New York City, the state would be much, much poorer.

A recent New York Times article quotes Governor David Paterson:

"Some people think that if you deny the bonuses, that the money's coming back to the American taxpayers," Mr. Paterson said. "It's actually the other way around: If you deny the bonuses, the money stays in the firms. It's when you pay out the bonuses that you start to get the huge tax collections that New Yorkers see."

He suggested that New Yorkers should defend Wall Street the way that California has defended its grape-growing industry or Iowa its corn production: "We need to stand behind the engine of our economy in New York, and that engine is Wall Street."

Paterson is no fool. He understands that he needs Wall Street more than Wall Street needs him. If bankers reject New York, then it's New York's loss. They can make money anywhere they please, really.

Lucky for New York, it appears they've chosen to stay, at least for the time being. After all, they're better off in New York than in London or Paris where enormous punitive taxes are being levied on bankers. But that doesn't mean New York State can count on that bonus tax revenue just yet.

For starters, deferred rewards in the form of stock options mean that this year's taxable income will be much smaller for bankers. For example, if Wall Street decides to defer a reward for, say, five years, then for the next four years, the state won't be able to collect taxes on it -- that compensation will not have been realized. In the long run that revenue may come in, but that doesn't help the state's fiscal crisis in the near-term.

This isn't only a problem for New York. In Britain and France, banks are bound to hold onto more of their profits this year, because it makes no sense to allow the government to take 50% of their earnings provided as bonus incentive compensation. So this year, those countries can expect to have significantly less tax revenue from the financial sector as a result of their punitive taxes. The firms will just pay out more next year instead, when the punitive tax (presumably) will no longer be in effect.

But this new bonus payout strategy could be harmful for the all government -- state and local -- from a long-term perspective as well. If a greater portion of bonus payouts are considered "Incentive Stock Options," then they might completely avoid income taxes. In that case, no compensation income is created if exercised under certain circumstances. Of course, when eventually selling the stock, capital gains will be incurred, but that only results in federal taxes, not state taxes. And remember, capital gains are generally taxed at a lower rate of 10-20% when the stock is held for more than a year, compared to the top federal income bracket of 35%.

It's interesting to note this accidental side effect of pressuring Wall Street to change its compensation strategy. While it might help to avoid some of the risk created in the financial markets, it will also result in less in tax revenue in the short-term and possibly the long-term as well.