Employee shares – A future in vested interests?

Since 1978, successive governments have promoted the idea of wider and Charles Elphicke say it’s time to question whether or not it works. employee share ownership with tax incentives. This government has proved no exception. The Treasury published a consultation document on increasing employee share ownership in December, seeking views on how the government could encourage more companies, particularly smaller and unquoted companies, to offer employee share ownership plans. The Treasury was also particularly concerned with how this strategy could increase productivity in the workplace.

In last week’s Budget, the chancellor proposed significant changes to the tax-advantaged Employee Share Ownership Plans regime. A new scheme has been announced where employees will be able to make contributions from their pre-tax income, which will be used to purchase shares in the company. Although it is claimed no decisions have been made about the three existing ESOP schemes, it seems likely that those schemes will be abolished over a transitional period.

Changes to the ESOP regime provide an opportunity to ask whether this kind of benefit really is suitable for unquoted companies, the best way to improve productivity, and whether long-term shareholding should be encouraged.

In fact, two studies appear to show that employee share ownership does not have a significant effect on productivity. First, a paper published by ACCA in January, based on a study of an ESOP scheme operated by SWALEC, a privatised utility, found that, ‘the results of the study must also throw serious doubts on whether the other hoped-for benefits of improved loyalty, motivation and profitability will materialise’.

The goal of increased productivity could potentially be achieved more effectively through a tax-advantaged performance-related pay scheme. The performance of a small business is more likely to be affected by the performance of individual employees than that of a large multinational.

Yet small businesses make less use of ESOPs than large businesses, either because of the expense or because they are not listed and their shares are therefore not liquid. For those smaller companies, ESOPs may not therefore be suitable, while it is still highly desirable that their employees should be incentivised.

Under ESOPs, shares are often handed out regardless of a company’s performance, and this practice is likely to continue under the new proposals. It is therefore poorly targeted, since individuals who make a significant contribution will receive a similar reward to those who make little contribution.

Performance-related pay is highly targeted since pay depends on the performance of the individual concerned and may therefore be more effective as a tool for the improvement of productivity.

Employers favour performance-related pay schemes since they focus employees’ attention on business objectives and help them to retain high achievers, or those staff whose skills are at a premium, according to an Incomes Data Services study last June. Support for the principle of performance-related pay is also strong among employees, according to the IDS paper.

Yet most do not operate performance-related pay schemes – even for management.

Tax incentives to encourage performance-related pay could therefore increase its use and thus increase productivity in line with the chancellor’s aims. So far as implementation is concerned, such pay schemes have attracted criticism in the past. When it became popular in the late 1980s, many mistakes were made; second-generation schemes, however, (such as competence-related and career-development pay) avoid earlier mistakes.

One way of tax incentivising performance-related pay would be to permit employers to pay employees a tax-free performance-related bonus of up to, say, 10% of salary – possibly from a designated, tax-advantaged performance fund. Inevitably, such a scheme would need to be very tightly drawn, to prevent abuse such as a ‘guaranteed’ bonus used in some cases to justify lack of salary increase. It could and should have a more direct and targeted impact on productivity, however, by directly rewarding those who contribute most.

Rather than creating two million new participants in ESOP schemes, the government’s desire to encourage long-term shareholding could have the effect of discouraging participation in ESOPs. Employees are only likely to be keen to participate in the improved share-price performance or profitability of their company and unwilling to participate in any downside.

Many employees may simply consider that if the company they work for fails, they will be out of a job as well as lose their savings – not all institutional savings managers are major players in the stock market. A further, perhaps undesired, side effect to the encouragement of long-term shareholding by employees is a disincentive on the part of employees to move jobs for promotion or other reasons. This could have implications for flexibility in the labour market.

The government’s desire to encourage longer-term share ownership may not be in employees’ interests. Many will already have invested their livelihoods in their job and it may be inappropriate that they should also have their savings invested there over the long term. The fact is that employee share schemes are ill suited to small and unquoted companies due to their set-up, running costs and the illiquidity of shares – problems which are avoided by performance-related pay schemes.

If the government’s aim really is to improve productivity, there are better ways of targeting tax incentives through the pay packet.

Mark Nichols is head of tax and Charles Elphicke is a senior assistant solicitor at City law firm, Cameron McKenna.

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