Why Tax Stock Buybacks?

Traders work on the floor of the New York Stock Exchange ahead of the closing bell on Aug. 15, 2018. Share buybacks are now one of the biggest sources of demand for stocks. Eduardo Munoz Alvarez/Getty Images

Commentary

The Biden administration has passed a 1 percent tax on stock buybacks. A stock buyback is when a public company uses its own cash to buy back its own stock. Sometimes it is financially in the best interest of the company to actually borrow money to buy back stock.

Democrats dislike stock buybacks because they don’t understand them or why companies do them. Many Republicans don’t understand them either. The provision was added to the tax bill that went through Congress last year to fight—you guessed it—climate change. Why corporate stock buybacks should be taxed to save the environment is beyond reason.

Why does a company buy back stock?

1. Excess cash on the balance sheet become takeover targets.
2. A company will buy back stock when it doesn’t have a better use for the cash, like investing in property, manufacturing facilities, and new equipment.
3. A company will buy back stock instead of issuing a dividend to shareholders. Dividends are heavily taxed in the current U.S. tax code (and is another reason why the Fair Tax is a great idea). Many institutional investors prefer buybacks to dividends purely because of tax reasons.
4. If a company issues a dividend, shareholders expect them to continue paying the dividend. If they don’t pay the dividend, that market interprets it as poor performance. One way around that problem is declaring a “one-time special dividend,” but companies have shied away from that.
5. Stock buybacks reduce costs for companies because buying back shares reduces the amount of shareholders. It reduces the number of claims on company capital.
6. It is a way of returning capital to investors.

It is true that the management of the public firm is incentivized to do a stock repurchase if they get most of their compensation through stock options. The buy back will offset the dilution effect of options and allow companies to manage earnings per share to make themselves look better.

Stock buybacks are not a “bullish sign.” They aren’t “bearish” either. It’s simply a use of company cash. When C-level executives use their own money to buy their own company’s stock, it’s a bullish sign.

In March 2020, Standard & Poor’s published some research on the returns of companies that engage in stock buybacks. Exchange-traded funds (ETF) that were “buyback funds” performed better on a long-term basis and had higher average monthly excess returns over benchmark indexes. Traditionally, companies issued dividends to return cash to investors. That changed in 1982, when the Reagan administration made it easier for companies to buy back stock. They enacted this change as a result of an overwhelming tide of academic research on corporate finance that showed there was more benefit to allowing buybacks than harm. Here is a table showing the total stock market capitalization, and the uses of capital by those companies. You can see how dividends have fallen out of favor compared to repurchases of stock.

What should the government do? Make the choices tax equivalent between repurchases and dividends by not taxing them at all. More money would go off corporate balance sheets and into the hands of institutional investors or individual investors. They would be rewarded for assuming the risk of owning the stock. The 1 percent tax will increase distortions in the market and make the stock market less efficient, decreasing the returns to pension funds and individuals.