A Model of Equity Based Compensation with Tax

In this paper, we develop a two-stage continuous time model of employee stock option (ESO) valuation under different tax regimes. We show that tax rules can have significant effects on ESO exercise behavior. In addition, we find that incentive stock options (ISO) are the optimal form of compensation for all levels of employees in the UK. In the US, restricted stock plans are preferred, and tax breaks offered by incentive schemes are only beneficial to employees with high liquid wealth (or small option holdings relative to wealth) or low risk aversion. We also analyze 83b elections for restricted stock plans in the US and find that making an election is a sub-optimal decision for both the employee and the firm.