While there are concerns about rising executive compensation and income inequality, taxing buybacks will do virtually nothing to address them while making companies, employees and the economy worse off.
| Guest columnists
Over the past few years, stock buybacks have become identified with corporate greed and wealth inequality. Critics claim that corporate executives increase their pay by using buybacks to give an abnormal boost to stock prices when cash should have been spent investing in new projects or increasing employee wages.
It is easy to understand how this criticism has gained popularity among politicians and social activists, culminating in proposals like a 1% excise tax on share repurchases. While there are concerns about rising executive compensation and income inequality, taxing buybacks will do virtually nothing to address them while making companies, employees and the economy worse off. There are three compelling reasons.
Reason 1
Stock buybacks alone do not increase stock prices. We know this is a common belief, but it ignores the fact that corporate cash is used to buy back stocks. For each share repurchased, the value of the company is decreased by the cost of that share. True, the remaining shareholders can claim more of the future earnings. But this increased claim is balanced out by the cash spent, so there is no boost to stock prices. For example, the S&P 500 Buyback Index, which tracks S&P 500 companies that buy back large amounts of stock, has underperformed the overall S&P 500 by 0.7% per year over the last 10 years.
Decades ago, stock buybacks nearly uniformly signaled management’s genuine belief that their stock was undervalued. That credible signal was then followed by abnormal stock price increases. However, in recent decades, buybacks have become preferred to dividends thanks to their flexibility and tax efficiency. So we now see companies using buybacks for a number of reasons, including giving extra cash back to shareholders. Over time, abnormal returns after stock buybacks have declined, but the belief that buybacks alone increase prices has persisted.
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Reason 2
There is not an endless supply of profitable projects in which companies can invest. Buyback critics assume that whenever companies have extra cash, they also have plenty of investment opportunities. This tends to be true of younger, less profitable companies. However, older, more profitable companies with lots of cash tend to have fewer investment opportunities. Not coincidentally, these companies are also the kind that buy back stock.
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Regardless, when companies buy back stock, the cash does not vanish from the economy. Instead, investors who sell their stock back to the company can use their cash however they want. This includes spending the cash on consumption, depositing the cash into banks (where it can then be loaned out) or reinvesting the cash in those younger, less profitable companies that need it. Apple has received lots of negative attention because they have spent hundreds of billions of dollars buying back stock over the last 10 years. However, if Apple had simply kept that cash or invested it in unprofitable projects, the economy would likely have been worse off.
Reason 3
Regulating buybacks will likely increase dividends. Sure, if a 1% excise tax (or some other regulation) is imposed on buybacks, it will certainly curb buyback activity. But the question then becomes: What do companies do with that cash? Buyback critics hope that companies will invest in new projects or increase employee benefits. But if companies choose to buy back stock instead of doing these things, they will almost certainly choose to pay out dividends as well.
Dividends and buybacks are similar methods of returning cash to shareholders. While dividends tend to be less flexible and tax-efficient than buybacks, these issues are unlikely to stop managers from simply increasing dividends in response to buyback regulations. And given recent evidence, this shouldn’t be a surprise. When companies had extra cash following the Tax Cuts and Jobs Act of 2017, S&P 500 companies increased buybacks in 2018 by over $250 billion.
But remember, those buybacks likely did little to boost stock prices, nor did they vanish from the economy. Instead, companies had too much cash and decided to give it back to stockholders to spend how they wanted. There are concerns about executive compensation and income inequality. However, penalizing stock buybacks does a disservice to employees, companies and our economy.
Greg Nagel is a full professor of finance whose research on executive labor markets and institutional investors has been presented to many Fortune 500 executives. His writings have been published in the Harvard Business Review and cited by the Federal Reserve and the New York Times. Nicholas Clarke is an assistant professor of finance who regularly presents his research on share repurchases at universities and financial conferences. His work has been published in leading academic journals including Financial Management and the Journal of Banking and Finance.