Against taxing corporate stock buybacks, which President Joe Biden proposed increasing 400 percent, but should be completely eliminated.
by Richard R. West and James A. Largay
Among the potpourri of tax increases in President Biden’s 2024 budget is a proposal to raise the nondeductible excise tax on corporate stock buybacks from 1 to 4 percent.
Many proponents, including Sens. Charles Schumer (D–NY) and Bernie Sanders (I–VT), claim their primary objective is not to raise revenue but to encourage companies to invest more in plant, equipment, and research and development.
Their basic premise—that the alternative to buying back stock is to reinvest the funds in company operations—and other criticisms of buybacks reflect misunderstanding of the role played by share repurchases in corporate activities. Once that role is properly understood, the case for taxing buybacks vanishes.
Corporate investment unaffected
Firms exist to determine what businesses to be in, how much to invest in them, and how to finance their activities. Having made these decisions, they then consider whether, how, and when to distribute cash to their shareholders, either by paying dividends or buying back stock.
Corporate investment decisions therefore affect distributions to shareholders, including buybacks—not the other way around. Tamping down buybacks, by taxes or other means, does not magically create profitable investment opportunities. Misunderstanding this is why some buyback critics mistakenly claim that buybacks starve firms of investment capital.
While those who mistakenly argue that stock repurchases starve companies of investment capital have played the leading role in the campaign to regulate them, they are hardly alone in their opposition. In addition, critics assert that buybacks are bad because they are used to manipulate earnings, inflate executive compensation, and provide a basis for a form of insider trading. On examination, however, none of those claims are any more persuasive than the notion that buybacks take away funds from productive corporate investment activities.
Earnings per share concerns
There are other criticisms of buybacks. One is that buybacks improperly manipulate earnings. Repurchasing stock increases all per‐share metrics, notably earnings per share (EPS). But an important 2016 study by McKinsey & Co. concluded that “the mechanical effect (of share repurchases) on EPS is totally irrelevant.”
To quote the study, “While improving a company’s EPS can improve the return to shareholders, the contribution of share repurchases is virtually nil.” Other studies reached the same conclusion: there is no empirical evidence of a positive correlation between stock buyback activities and total returns to shareholders.
As the McKinsey study succinctly concludes: “It’s the generation of cash flow that creates value, regardless of how that cash is distributed to shareholders. So share repurchases are just a reflection of how much cash flow a company generates.”
Executive compensation fears
Another criticism is that buybacks can be used to inflate executive compensation. According to Schumer, stock repurchases are “one of the most self‐serving things that corporate America does.” The apparent reasoning behind this claim suggests that the above‐discussed “mechanical effect” on EPS allows companies to use buybacks to achieve EPS targets that raise executive compensation.
Although theoretically possible, the processes of determining high‐level corporate pay packages are more sophisticated than that. Boards of directors and their compensation consultants can easily identify differences in EPS resulting from buyback activities.
Moreover, the growing involvement of major institutional investors in monitoring corporate governance quality virtually guarantees that they do so. The empirical evidence is clear: managements of companies that regularly use buybacks do not earn more, on average, than executives of comparable firms that eschew buybacks.
Stock price manipulations
There is also the criticism that buybacks can be used to engage in manipulative stock trading activities. The typical argument is not that managers personally employ insider information for their own benefit, but that they use it to make corporate stock buybacks when they “know” their company’s stock is “cheap” and take advantage of selling shareholders.
Although major buyback programs can be accompanied by press releases about why a company’s shares are “undervalued,” the empirical evidence does not give managements high marks for buying back stock “on the cheap.” The opposite is closer to the truth: as the above‐mentioned McKinsey study noted, “Most companies do not time their purchases well.” Also, it is important to remember that selling shareholders do so voluntarily.
Wall Street Journal columnist Jason Zweig criticized buyback activities because companies have repurchased substantial amounts of stock shortly before getting into serious trouble. He specifically cited Bed Bath and Beyond, which purchased more than $11 billion of stock in recent years, and now has filed for Chapter 11 bankruptcy. But a case can be made that such buybacks were very timely because they distributed cash to shareholders rather than reinvesting it in a declining business. Yet the track record for the timing of buybacks is hardly evidence that managements have taken advantage of selling shareholders.
Additionally, the public policy position on the matter of seeing buybacks as some form of insider trading is clear. Ever since the Reagan administration, corporate stock buybacks have enjoyed a “safe harbor” from charges of insider activity.
Buybacks vs. special dividends
We now return to where we started, recognizing that stock buybacks are one way for companies to distribute cash to shareholders. The other way is to pay dividends. Both involve debiting the company’s capital accounts and crediting cash. But there is no change in the company’s operating assets or their financing; the “corporate pie” remains the same, except for the number of pieces into which it is divided and who owns them.
The relevant questions are when and why companies choose to pay dividends or buy back stock. To begin, note that buybacks have never been seen as a general alternative to paying regular quarterly dividends. Even when the tax laws made buybacks more tax advantageous to shareholders than they are today, regular dividends flourished.
The reason for this is that many investors have strong preferences for stable, predictable cash flow streams. Corporate dividend policies—as an important example of the so‐called “clientele effect”—have reflected this preference for many decades. Companies are very reluctant to cut regular dividends and firms with a long record of annual dividend increases are well‐known as “dividend aristocrats.” In 2022, buybacks exceeded $1.2 trillion, whereas regular dividend payments exceeded $1.7 trillion.
Instead, buybacks are seen as akin to paying “special” dividends. Both deal with nonroutine situations such as selling an operation, changing capital structures, dealing with highly cyclical operating results, or distributing a massive cash hoard accumulated over time. Apple’s buybacks of the past decade likely illustrate the last of these. Neither buybacks nor special dividends create an expectation of continuing payments or emit false signals about the future course of regular dividends.
Obviously, an excise tax on stock buybacks forces companies to reconsider their use. The Congressional Joint Economic Committee estimated that the current 1 percent tax will raise about $78 billion over the next decade, implying that the committee still expects total buybacks to exceed $7 trillion during this period. No doubt this is why there is a proposal to increase the tax to 4 percent.
Two questions present themselves from a company’s perspective: First, should the firm continue buying back stock and paying the associated tax? Second, if buybacks are out, how should the firm deal with the excess cash that had previously been distributed via buybacks? We have no way to know how any given company might answer the first question, other than to say what is obvious: the higher the tax, the greater the likelihood that it will decide to eschew buybacks.
As for the second question, it seems clear that simply retaining the cash is not a viable way to proceed. Because the funds involved were being distributed precisely because they were deemed to be excessive, retaining them just creates a greater need for a larger distribution sometime in the future.
Some companies will tweak their regular dividend policies to absorb a portion of the excess cash. But taking this approach runs the very real risk of sending false signals to shareholders about the future course of regular dividends. Regular dividends are just that; funds for buying back stock are nonroutine distributions. Combining the two reminds us of the old saw about trying to mix oil with water.
By a process of elimination, then, we conclude that most companies seeking to save tax money by reducing or eliminating buybacks will end up increasing their use of special dividends. Like buybacks, special dividends avoid sending false signals to shareholders and can be turned on and off at will.
Unfortunately, the taxation of funds distributed as special dividends is exceedingly complex. Depending on the circumstances, they can be taxed as ordinary income, capital gains, a return of capital, or in many cases some combination of all three.
Without taxes on buybacks, companies were incentivized to decide between repurchasing shares and paying special dividends principally on the basis of which of the two produced the best after‐tax results for shareholders. What companies have done over the years clearly indicates that in the majority of circumstances the tax consequences for shareholders were better when shares are repurchased.
More government revenue, not more corporate investment
Imposing the excise tax therefore means that (1) companies that continue buying back stock will be subject to added taxes, and (2) shareholders of companies deciding to use special dividends instead will likely be paying more taxes. Either way, taxing buybacks produces more revenue for government, while doing nothing to foster more corporate investment in plant, equipment, and R&D.
Implicit in all this is that taxing stock buybacks creates a conflict of interest between company managements and their shareholders. Will managements do what is best for their firms or what is best for their owners? Alas, there simply are no obvious answers to questions such as these.
The Apple case offers a dramatic example of the potential damage from a 4 percent excise tax on buybacks. Some 10 years ago, following a massive cash accumulation under Steve Jobs, Apple started both a modest quarterly dividend and an aggressive stock buyback program; the latter totaled around $90 billion in 2022. The proposed nondeductible 4 percent excise tax would have levied a $3.6 billion deadweight cost on the company and would likely have forced serious consideration of using special dividends to the detriment of shareholders.
Meanwhile, the empirical evidence indicates that neither buybacks nor cash used to pay regular or special dividends have negatively affected corporate investment activities. Princeton economist and legendary financial writer Burton Malkiel recently noted in the Wall Street Journal that a study of the period 2007–2017 found that “research and development and capital expenditures soared over the same period when shareholder payouts and buybacks were rising sharply.”
The bottom line
In summary, stock buyback taxes are just another government interference with private sector decision‐making, negatively affecting capital market efficiency without any offsetting economic benefits.
Fortunately, the current composition of the House of Representatives makes it highly unlikely that a fourfold increase in the excise tax on buybacks will become law anytime soon. But a much better outcome is readily apparent: repeal the 1 percent tax as soon as possible.
Originally published by the Cato Institute. Republished with permission under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.
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