long in favor of what we were trying to do. Everybody was affirmative in what we were trying to do. This is the first damper we have had on our efforts. [The prepared statement of Mr. Lubick and answers to Senator Long's and Senator Gravel's letters follow:] STATEMENT OF DONALD C. LUBICK, ASSISTANT SECRETARY OF THE TREASURY FOR TAX POLICY Mr. Chairman and members of this distinguished Committee, I appreciate the opportunity to discuss with you issues surrounding stock ownership plans for groups of employees or citizens. I believe that the Committee is most interested today in trying to define the appropriate governmental role, if any, in encouraging such forms of ownership of stock. ADVANTAGES OF BROADENED STOCK OWNERSHIP Let me distinguish between the goal of broadening stock ownership generally and the more specific goal of encouraging employees to have a stake in the success of their own corporations. The two goals are related, but different. The goal of expanded stock ownership is to spread ownership of America's corporations across a broader range of people. These people would then share in the success of the corporate sector of the economy. In effect, corporate wealth would be distributed more widely across the population. In giving employees a stake in their own corporations, on the other hand, the goal is to establish a common economic bond between employer and employee, so that each has a share in the other's success. Together they would share a mutual interest in increasing the productivity and profitability of the firm. If the stake is provided through real ownership, then the employees would presumably be given full information on the operation of their companies and the opportunity to participate in and vote on the setting of policy; that is, they would exercise some control over the company. In my discussion of the government's role of encouraging stock ownership, I will examine the extent to which governmental policies are efficient and equitable means of reaching those goals. THE GOVERNMENT'S CURRENT ROLE In order to proceed, we must first ask the question: What is the government's current role in encouraging stock ownership? Through pension and profit sharing funds the American worker has indirectly come to own a large share of the existing productive capital of this country. The growth of such plans is fostered by the generous tax treatment accorded to employer contributions to qualified pension and profit sharing plans, and to the earnings of those plans. Neither the employer contributions to the plans nor the earnings of the plans are taxed currently to the employees. Only at the time of final distribution are employees taxed on benefits in excess of their own initial contributions. Of course, investments by pension and profit sharing funds are not generally designed to result in employee ownership of stock of their own employers; nonetheless, they have indirectly broadened stock ownership and led to a wider distribution of corporate wealth. The tax system has lent additional encouragement to employee ownership of their own employer's stock through stock bonus plans and various kinds of ESOPS. For a number of years employer plans providing for distribution to employees solely in the stock of the employer have been accorded special benefits. Like a profit-sharing plan the employer may maintain discretion over contributions; a fixed formula is not required. However, contributions are not limited to amounts set aside out of current or accumulated profits. Moreover, in the case of certain distributions of employer stock, tax on the amount of unrealized appreciation may be deferred until the employee sells the stock. The Employee Retirement Income Security Act of 1974 (ERISA) continued the encouragement for investment in employer stock by allowing unlimited investment in such stock by defined contribution plans without the normal requirement of diversity, although such an investment is subject to prudence requirements other than those relating to diversity. ERISA also lent encouragement to a special leveraging type of ESOP. This type of ESOP provides for the employer to guarantee a loan which the ESOP trust uses to purchase stock in the employer's company. The employer then makes contributions to the trust sufficient to repay the principal and the interest on the loan over time. ERISA provides for these plans by providing an exception to the general rule which would prohibit the employer from guaranteeing a loan made to the trust. The Tax Reduction Act of 1975, as amended by the Tax Reform Act of 1976, took another approach to encouraging employee ownership of employer stock. It provides for an extra investment tax credit of 1 percent of qualified investments (plus another 2 percent if matched by employee contributions) for contributions to an ESOP. Excluding the employee matching contributions, if any, the tax credit ESOP is funded entirely from tax liability owed to the Federal government. A tax credit ESOP is thus a plan in which the government in essence purchases stock for employees, based upon the amount of investment of the employer and usually at no cost to either employer or employee. It is a grant of varying amounts of stock from the government to a limited group of employees. PROPOSED EXPANSIONS OF THE GOVERNMENT'S ROLE Two bills before you today would expand the government's role in determining stock ownership and portfolio choices of individuals. S. 3241 would expand tax credit ESOP coverage, or direct purchase of stock by the government. by allowing the employer a credit for contributions to the ESOP equal to the greater of 2 percent of the employer's qualified investment for the year or 1 percent of the aggregate participant's compensation paid by the employer during the taxable year. While S. 3223 is not as directly comparable to a government purchase, it would provide significant tax incentives to General Stock Ownership Plans ("GSOPs") similar to those available through leveraging ESOPS in the employment context even though there is no employment or other bond between the corporate issuers of stock and the intended beneficiaries. S. 3223 would confer tax exempt status on a trust established to facilitate the ownership of corporate stock by the residents of the United States or a state or local jurisdiction. The trust could finance the acquisition of corporate stock through the issuance of tax exempt debt. Corporate issuers of stock to a GSOP would be permitted to deduct dividends paid to the GSOP. After the debt is paid the stock would be distributed to individual recipients tax free. Thus, corporate income used to finance the purchase of stock through a GSOP would not be taxed either to the corporation or the beneficiaries until the individual beneficiaries sell or otherwise dispose of shares they receive from the plan or receive cash dividends. With respect to shares issued to a GSOP trust, the individual and corporate income taxes would be fully integrated via a dividends paid deduction. Beneficiaries would obtain two principal tax benefits: 1. Beneficiaries would enjoy the benefit of borrowing at the lower rate applicable to bonds paying tax-exempt interest, a privilege generally limited to borrowing for governmental purposes. 2. Income used to pay the debt would be tax-exempt at the corporate level and individual tax would be deferred until sale and would then be payable at capital gains rates. RULES GOVERNING THE GOVERNMENT'S ROLE Having described the current law and some proposals to change that law, we must now turn to the question of what type of governmental role is most appropriate to the encouragement of stock ownership. Providing an equitable and meaningful program at limited revenue cost.— As in the case of other expenditures programs, if the government is to be financing the purchase of stock for its citizens, we must ask the question: How many resources should be devoted to the program and how should the benefits of the program be distributed to insure equity? In the context of employee stock ownership benefit plans, there are approximately 100 million workers and 200 million citizens in the United States, so that for each $1 billion in expenditures an average of $10 per worker or $5 per citizen in stock can be purchased. For $10 billion, $100 per worker or $50 per citizen is possible. Note that $100 per worker represents approximately 1 percent to total payroll. There is a means to provide a greater amount of stock per average recipient at no greater Federal revenue cost-the government can effectively limit the number of recipients of the grant. In a sense, this is what the investment credit ESOP does by limiting the government grant to employees of those firms that have made investments. However, there is no rationale behind providing one worker a level of contribution different from that received by another simply because their employers invested different amounts of money in plant and equipment. As demonstrated in Table 1, the current law favors workers in utility, oil, communications and other capital intensive industries. The government grant can vary from zero dollars per worker in one company to several hundred dollars in another company. One bill before you today tends to eliminate some of that discrimination by allowing calculation of the government grant on the basis of 1 percent of compensation of employees or 2 percent of qualified investments. For most businesses, 1 percent of compensation is greater than 2 percent of investment, and, therefore, the bill would limit the number of workers who received greater than average benefits because of the industry in which they worked. The other bill before you today, S. 3223, would impose arbitrary limitations of a quite different sort. Individual citizens would benefit from the legislation authorizing general stock ownership plans only if they resided in a jurisdiction whose bonding capacity was such that it could be used in furtherance of corporate equity investments, and even then only to the extent that each state chose to use available resources for that purpose. It, therefore, could be expected that while the citizens of some states might benefit significantly, the citizens of others would not benefit at all. I believe that one of the major dilemmas to be faced by this Committee is to meet standards of equity and provide meaningful grants while at the same time to keep government expenditures on the program within reasonable limits. To directly provide the average worker with any significant amount of stock would cost the government sizeable revenues which would eventually require the same worker or citizen to pay a sizeable tax. To limit government cost requires either reducing the average grant to an insignificant amount or narrowing the number of qualified recipients. Maintaining freedom of portfolio choice.-As I have stated, it is desirable for employees to have a stake in their employer's success: divisions can be reduced and the incentive to work can be increased. Yet the ideal form of such a stake varies from company to company and individual to individual. Past history indicates employers and employees will develop such arrangements without tax benefits of the magnitude provided by S. 3241. Many firms give the worker a stake in the success of the corporation by providing for participation in profits in a manner other than specifically allowed under ESOPs. For instance, millions of workers currently participate in over 150,000 profit-sharing plans which do not share in the extra investment tax credit available to ESOPS. In many cases, there may be special reasons why employees would prefer to hold an investment other than their employer's stock. An employer's stock may be too risky for an employee and an asset which he or she would prefer not to own. Moreover, investment in employer stock may enhance the possibility of self-dealing. This is especially true in the case of stock that is hard to value or sell on the open market. Traditionally, other government programs in this area have remained neutral in the portfolio decisions of individuals and firms. This is best exemplified in the tax advantagés that the government offers savings in pension, profit sharing and stock bonus plans. An essential feature of this particular tax incentive is that it applies across all investment assets, not just stock. The government remains neutral in the choice of plan negotiated by the employer and employee, and in the types of investments held by the plan. Nonetheless, broadened owner. shin of securities has occurred because pension plans have chosen to buy stock and because many companies have established profit sharing and stock bonus plans. By 1977 about 16 percent of the increase in the financial assets of households, or 23 percent of their net individual saving. came from an increase in private pension reserves. Thus, by merely maintaining current law regarding these plans, stock ownership will continue to expand. ADDITIONAL COMMENTS I would like to add some comments on certain specific features of S. 3241 and S. 3223. 8.3241 The theory underlying an ESOP is to give an employee ownership of a capital interest and, in particular, an interest in his or her employer on an ongoing basis. Present law does not fully carry this out. Prior to a distribution from an ESOP, a participating employee has only an indirect ownership interest in the employer corporation through the securities allocated to his or her account under the plan. An employee is further removed from true ownership, since there is no requirement for the pass-through of voting rights under a leveraging ESOP, and under the bill a pass-through in the case of an investment credit ESOP would no longer be required in all cases. Many persons have argued that, consistent with the concept of employee ownership, the employee should in all cases be entitled to voting rights and access to information generally given to shareholders. The bill seems to impact further upon the employee's status as an owner, since it will allow the ESOP to provide for a cash election in lieu of a distribution of employer stock. This reflects the difficulty of reconciling the ESOP theory with the desires of both the employer and the employee regarding ownership by the employees of a minority interest in a closely-held business. Substantial owners of such a business often do not want to dilute either their stock ownership or their actual conrtol, and rank-and-file employees may not want to hold stock in the business. The bill represents an effort to mesh these concerns, but we would suggest further study pointing toward developing a statement of policy which will reconcile the various interests. S. 3241 would expand the current ESOP provisions by allowing companies an option to base their credit on investment or on some wage base. Treasury does not believe that the amount of the government credit or grant should be based in any manner upon the amount of investment of the firm. As noted above, present law discriminates in favor of certain industries because it is tied to the investment base. It also makes long-range planning for retirement savings difficult. We, therefore, believe that if Congress enacts further legislation use of the wage base is superior to use of the investment base. However, we also believe that attention must be paid to the cost of ESOPs. By limiting the beneficiaries, present law does at least seek to limit the cost of ESOPS. An alternative means of reducing the cost is limiting the amount of wages which are eligible for stock through an ESOP. In terms of broadening stock ownership, it appears counterproductive to provide a $100,000 a year executive with $1,000 or more in stock while providing one-tenth that amount to a $10,000 a year worker. In the pension laws this type of split is allowed on a theory of equal percentage wage replacement. However, in the case of an ESOP program designed to expand stock ownership, this type of split works counter to the expressed goal of the program. The cost could also be reduced if the government subsidy were less than 100 percent of the total outlay. It is reasonable to assume that behavior could be influenced in the desirable direction if the cost to those concerned were substantially reduced without the necessity of making the price zero. Finally, if the base for the credit is to he related to compensation, the Treasury would encourage use of some base which can be readily calculated by employers such as wages subject to income tax withholding. It is not at all clear that aggregate compensation is measured by employers. A new wage base for the credit should require as little extra administration for employers as possible and should not require much new regulatory activity to define "compensation" for purposes of ESOPs. The bill also contains a number of technical issues which are discussed in the appendix to my testimony. S. 3223 As for S. 3223, it contains two other features on which I would like to comment specifically. The first is that the bill provides for full integration of the corporate income tax with respect to stock issued to a GSOP trust. As I have stated, complete integration of the corporate and individual income taxes is a matter in which the Treasury has a continuing interest, but which we feel is very much in need of further study. We would be opposed to the ad hoc method by which S. 3223 would result in integration but only with respect to stock issued to a general stock ownership plan. This is especially so because the concept of integration assumes that tax will be payable at the shareholder level in lieu of the corporate income tax. It seems inconsistent with this concept to eliminate the corporate level income tax while the shareholder tax is deferred and, in this instance, partially converted into capital gain. Second, the proposal specifically would amend the Code to exempt from Federal income tax interest on indebtedness incurred by a GSOP trust to purchase equity securities. It is inconsistent with the principles underlying section 103(b), which restricts the issuance of industrial development bonds, to permit tax-exempt debt to be used to acquire an interest in a profit-making venture. Furthermore, this amendment could have a serious, adverse impact on the yield differential between taxable and tax-exempt securities to the detriment of traditional state and local borrowing. The goal of the GSOP could be accomplished with less departure from traditional tax principles if the state or local government role (in ventures of the sort for which the GSOP proposal is designed-large scale ventures to develop and exploit natural resources) was direct ownership of the enterprise or some portion thereof. If such an arrangement were viewed as the exercise of an essential government function the income earned by the State would be exempt under section 115 of the Code. Such investments could be financed with the state's debt and, when the debt was retired, the ownership interest would be distributed to the citizens of the state (who would be taxable at that time). It is not at all clear, however, that states should have freedom to engage in traditional, profitmaking activities and derive the resulting income free of tax. In fact, the enactment of the unrelated business income tax on exempt organizations suggests a contrary conclusion. It is equally unclear that states should be able to carry on such activities with capital borrowed at tax-exempt rates. I realize that the massive accumulations of capital required for large-scale resource development present an appealing case for facilitating state involvement, but, in other contexts, it may appear that the states are being offered an opportunity to engage in profit-making ventures at an unfair, tax-induced, competitive advantage. The Chairman also announced that the Committee wishes to examine the degree to which agencies of the Federal government have complied with section 803 (h) of the Tax Reform Act of 1976. In regard to the activities of the Treasury Department, that section relates to changes in the proposed regulations which were issued in connection with leveraging ESOPS authorized by the Employee Retirement Income Security Act of 1974 (ERISA). At this point we merely note that the final ESOP regulations were published after the enactment of section 803 (h), and we believe that these regulations confrom to both the letter and the intent of that statutory provision and is legislative history. I will be pleased to answer any questions from the Committee. 1 Statistics of Income *** 1976, Corporation Income Tax Returns. Preliminary Data. U.S. Department of Labor, Division of Labor Statistics. Establishment data on employment do not match exactly with tax data by type of industry, especially in the case of conglomerates where the tax return may be placed in 1 industry and establishment data may represent employees as being in several industries. Less than 1/10 of 1 percent. Not available. |