As part of the new Inflation Reduction Act that President Biden signed this week is a new 1% tax on corporate share buybacks. While this new tax is beneficial to the U.S. Treasury, it will reduce economic value to companies and their shareholders because it will force companies to change how they return profits to shareholders.
A share buyback is when a company buys their own stock in the market at whatever the market price for their shares is. Companies have share buybacks to return excess cash they have on hand back to shareholders; they are an alternative to making dividend payments. Share buybacks rose to a record high in 2021 and are on a pace to succeed that record this year, with over $500 billion paid out in buybacks so far this year. Dividend payouts are also at record highs this year, with companies in the S&P 500 having paid out around $280 billion in dividends this year through the second quarter.
The argument against buybacks is that executives use them to increase their pay rather than investing in their companies and paying higher wages. Executives do receive higher compensation because of share buybacks. But it also has been shown that, on average, companies who conduct buybacks have their share prices rise after the announcement by 3.5% and continue to rise thereafter, above their peers, by 12%. This idea that executives increase their pay via buybacks only works if their company’s stock price rises because of a buyback, but the price will only increase if investors see the buyback as value enhancing.
Do buybacks cause firms to underinvest in the growth of their companies? No. Regardless of a buyback, those companies with cash lying around do not see alternative internal investment to use the cash on. If they did, they would not have this excess cash undeployed. Shareholders want any cash companies has to be used on the highest-yielding possibilities. But at the same time, if a company does not have a high return use for the cash, shareholders prefer to have it paid out rather than sitting in a company invested in low-yielding financial assets. Furthermore, if companies are not making effective use of their capital, they would see their share prices fall, not rise.
There is a preference buy shareholders to receive payments via a buyback over dividends because they might have lower tax implications than dividends. But it is incorrect to say that buybacks are not taxed; they are simply taxed differently than dividends. Since buybacks cause stock prices to rise, investors ultimately must pay taxes on the capital gains they accumulate because of the buyback.
With dividends all shareholders must pay taxes on them when they receive them. With buybacks, only those who sell their shares as part of the buyback program are required to pay taxes at that time. Other shareholders do ultimately have to pay taxes on the effect of a buyback, but not until they sell their shares. The tax rate you pay on dividends and capital gains depends on how long you own a stock. For dividends, they are taxed at your personal income tax rate unless you own the stock for 60 days before and after when the dividend is paid, and then you pay the long-term capital gains rate. Capital gains are taxed at personal tax rates if you own the stock for less than a year; otherwise, they are taxed at the long-term capital gains rate.
There has been commentary that this tax on buybacks will force companies to pay out their excess cash via dividends and it is better to have dividends than buybacks. This is correct; however, not in the manner that these politicians are imagining. The argument assumes that share buybacks cause executives to be short-term focused. Regular dividends, which are paid frequently, cause executives to focus on how they are going to pay their dividends, buybacks occur over time and executives can change their minds in the future.
The outcome of the new buyback tax is that we will see companies having more special dividends, not regular dividends. Setting up and managing regular dividends gives executives less flexibility as to how to manage their cash flows. It has been shown that when a company lowers than regular dividend payments the market penalizes their stock price. Therefore, management avoids changing their dividend policy, thereby restricting their ability to manage their cash flows.
Forcing companies to change their payout policies to shareholders has a net negative economic impact. The effect of the new share buyback tax is that companies will start paying out more cash in special dividends than they have in the past relative to their share buybacks.
History shows that companies and investors prefer buybacks over dividends, so they view buybacks as having more economic value than dividends. The new buyback tax will destroy this value.