The Enron Debacle

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

TPC Discussion Paper No. 6

The Urban-Brookings Tax Policy Center

The Tax Policy Center (TPC) aims to clarify and analyze the nation's tax policy choices by providing timely and accessible facts, analyses, and commentary to policymakers, journalists, citizens and researchers. TPC's nationally recognized experts in tax, budget and social policy carry out an integrated program of research and communication on four overarching issues: fair, simple and efficient taxation; long-term implications of tax policy choices; social policy in the tax code; and state tax issues.

A joint venture of the Urban Institute and the Brookings Institution, support for the TPC comes from a generous consortium of funders, including the Ford Foundation, the Annie E. Casey Foundation, the Charles Stewart Mott Foundation, and the George Gund Foundation.

Views expressed do not necessarily reflect those of the Urban Institute, the Brookings Institution, their boards of trustees, or their funders.

Contents

I. INTRODUCTION
II. RETIREMENT AT RISK?
Types of Plans
Role of the Tax System
Public Policy Issues
Proposals for Change
Are ESOPs the Fly in the Ointment?
Summing Up
III. STOCK OPTIONS
Tax Treatment of Stock Options
Issues in Tax and Accounting Treatment of Options
IV. BOOK VERSUS TAX CONFORMITY
Sources of Book versus Tax Differences
Evidence on Book versus Tax Differences
Enron's Experience
Possible Remedies
V. CONCLUSION
REFERENCES

I. INTRODUCTION

Many employees lost both their jobs and much of their life savings in the wake of the Enron collapse. The retirement plans of Enron workers containing large shares of company stock were not only permitted by regulation, but were actually sanctioned and actively encouraged by the Internal Revenue Code. When Enron appeared to be profitable, it was paying little or no corporate income tax. Yet the spectacle of apparently profitable companies paying virtually no corporate tax has become so common that no one considers lack of taxable profit a sign of a failing company. Enron deducted stock option spreads from taxable income, but not from profits reported to stockholders. The company also set up hundreds of offshore partnerships that it classified as debt when computing corporate income taxes and equity when reporting to stockholders—exactly the outcomes most beneficial for a company attempting to conceal financial trouble.

Did tax rules facilitate the Enron debacle and its unhappy outcome for ordinary stockholders and employees? And are there lessons to be learned for shaping tax policy as a result? Answering these questions requires examining three major areas of federal tax law: the treatment of retirement plans; the treatment of stock options; and the discrepancy between the treatment of assets, income, and costs for reporting to the Internal Revenue Service (IRS) versus reporting to stockholders. These issues overlap. For example, an important item differentiating Enron's tax and book income was the deduction of exercised stock option spreads for tax, but not for book purposes.

The analysis that follows makes three major points. First, if we wish to discourage excessive concentration of retirement plan investments in employer stock—and there seem to be good reasons to do so—we need to recognize that even if we adopt provisions that encourage more prudent diversification behavior in some types of plans, we are providing the juiciest tax benefits to employee stock ownership plans (ESOPs)—plans that can invest solely (and must invest primarily) in employer stock. To achieve our objective, we need to reconsider those tax benefits—including the one enacted on the eve of the Enron bankruptcy—that encourage employer stock holdings. In other words, to use an old phrase, perhaps the federal government should put its money where its mouth is. Second, providing stock options may not be the best way to encourage executives to act in the best interest of stockholders, but our current tax benefits may encourage the granting of too many stock options. Finally, the tax code can address many book versus tax income discrepancies. A list of possible tax proposals that would address these issues should at least be laid on the table. One such reform might be never to permit capital raised to be treated as debt for tax purposes unless it is also treated as debt for financial reporting purposes. This reform would address many of the activities that contributed to Enron's low tax liability in the face of high reported profits.

This report is available in its entirety in the Portable Document Format (PDF).

About the Author

Jane G. Gravelle is a senior specialist in economic policy at the Congressional Research Service of the Library of Congress.

Acknowledgments

The author thanks Len Burman, Richard Hinz, and Pam Perun for comments. Any errors or opinions are the author's and should not be taken to represent the views of Congressional Research Service or the Library of Congress.

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