Stock options explain disparity in income growth (aka rich get richer)

Summary: Typical wages for working class Americans have not grown at the proportional rate as productivity, yet the total amount paid out in salaries is also growing. The money must be going somewhere, and it’s not to the middle class. The Wall Street Journal shows that it’s going to the richer folks, mostly into their stock options.

9/18/2006

Link

THE OUTLOOK

How Stock Options Muddle
The Relationship Among Wages,
Corporate Profits and Inflation
By GREG IP
September 18, 2006; Page A2

Scorekeepers at the Commerce Department last month discovered that American workers were earning far more than previously estimated — and that created an economic puzzle.

The new data were out of step with other measures showing sluggish wage growth, a factor in widespread worker dissatisfaction turning up in the polls. And the increased income wasn’t matched by more production — that is, in gross domestic product — as it should have been.

Solving this puzzle is important for understanding how well American workers and companies are doing and whether rising wages pose an inflation threat.

The answer appears to be stock options, a growing part of compensation for top-end workers. Accounting for them properly has been a major source of controversy for companies. Now it is complicating the government’s economic accounting, as well.

The Commerce Department’s Bureau of Economic Analysis, which keeps the nation’s GDP books, treats profits from the exercise of options as labor income. But options aren’t counted in most other measures of wages. So the BEA reports — which are important both to markets and the Federal Reserve — may be overstating the extent of wage pressure, and, for related reasons, at least temporarily understating profits.

Here is what’s going on:

Last month, the BEA declared that labor income for all Americans in the first half was an annualized $95 billion, or 1.3%, more than it had estimated just a month earlier. This suggested Americans were flush with cash, welcome news for those worried about a slowing economy, but it also raised inflation alarm bells.

From 2001 to 2004, the productivity of American workers — the amount they produced for each hour on the job — rose enough so that companies could pay somewhat higher wages without raising prices. The new data changed that benign picture. They showed that business compensation per employee-hour soared almost 8% in the year through June. Adjusted for higher productivity, labor costs jumped 5%, a near six-year high.

But something didn’t seem right. That jump in labor costs should have squeezed profit margins, yet margins are at a 40-year high. Plus, the 8% rise in hourly compensation far outstripped better-known measures of labor costs. The Labor Department’s employment-cost index — which includes hourly wages, benefits and bonuses — rose just 3% in the same period. The weekly wage of workers at the statistical middle rose only 2.5%.

Adding to the mystery was the economic-textbook fact that Americans’ income — wages, benefits, profits, etc. — is supposed to equal the value of what they produce. But after the revisions, gross domestic income was rising much faster than GDP. The two seldom match perfectly, but the divergence was striking.

The likely explanation: stock options. The income earned when employees cash in stock options is counted in both gross domestic income and the Labor Department’s productivity-adjusted labor-cost measures, but not in most of the other wage measures.

“The stock market was strong in the first quarter, so that suggests probably quite a bit of stock-option exercise,” says Brent Moulton, associate BEA director for national economic accounts. Because higher-paid employees are more likely to have stock options, this helps explain why the advance in labor income doesn’t reflect the average worker’s experience.

Stock options also might have led the BEA to overstate profits, and thus gross domestic income. Here’s why: Corporations keep separate books for shareholders and for the Internal Revenue Service. The BEA uses the latter to measure profits.

The two treat stock options differently. When reporting profits to shareholders, companies must expense only the fair value of the option on the day it was granted. That’s usually quite low (unless the option was backdated, but that’s another story).

But when reporting profits to the IRS, the company may expense the (usually) far-higher value of the option the day it was exercised. So in periods of heavy options exercise, shareholder profits will be higher than taxable profits.

“For wages and salaries, we now have very accurate data,” Mr. Moulton says, thanks to speedier access to unemployment-insurance data, which track both regular wages and options. For corporate profits, though, the agency relies a lot on reports to shareholders. Because these generally exclude full options expense, the BEA must estimate it. The BEA must wait as long as a year for the annual reports for the details on option expense, and two years for comprehensive IRS tabulations.

“We sometimes can get quite large revisions when we get the IRS data,” Mr. Moulton says. It is “a possibility” that profits will be revised down when BEA gets the complete detail, he says.

If options expense has squeezed profits, is that a problem for inflation? Probably not. Corporations don’t think of stock-option expense as ordinary labor compensation, says Robert Willens, a tax-and-accounting expert at Lehman Brothers. Option expense is “dependent on how the stock does, which is sort of out of the company’s or the employee’s control.”

Thus, investors and the Fed are likely to discount swings in the BEA labor-cost measures once they figure out they have more to do with swings in the stock market than anything else. The bottom line: Wage increases, while accelerating, aren’t flashing a warning sign.

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