The Effect of the Beneficial Tax Treatment of Employee Stock Options on Option Granting Behavior: An Empirical Examination

This paper empirically examines the effect of the beneficial tax treatment, to employees, of employee stock options on option granting behavior. On February 27, 2000, the capital gains inclusion rates declined and the applicable tax rate on stock option employment income also declined. Accordingly, I expect an increase in the usage of stock options post February 27, 2000 after controlling for other factors affecting the granting of employee stock options. I test my hypothesis by regressing the stock option compensation expense of Canadian companies, with the necessary information, over the period 1996 to 2004 on a dummy variable equal to one for year ends post February 27, 2000, and control variables. There is weak evidence in support of my hypothesis that stock option usage increased post February 27, 2000 due to the tax changes. This paper contributes to the literature by showing that employee level taxation may have at least second-order effects (if not first-order effects) on employee stock option granting behavior. This paper also has tax policy implications.