S&P 500 companies spent more than $800 billion on share repurchases in 2018. A 50% increase from 2017 and an all-time high in terms of dollars spent on buybacks, these statistics have intensified the debate among economists, politicians, businesspeople, and the like on the validity of this use of cash as a rational business expense and their effect on the US economy, innovation, and workers.
Share buybacks began their rise to popularity in the 1980s after the SEC’s adoption of Rule 10b-18. This Rule created a safe harbor for companies to buy back shares without fear of market manipulation charges, provided that the buybacks meet certain conditions. Since that time, companies have increasingly used share repurchases alongside dividends as a way of dispensing cash to shareholders.
The conditions dictated by Rule 10b-18 are largely viewed as permissive of share repurchases and concern the “manner, timing, price, and volume” of the expenditure. Proponents of buybacks favor the SEC’s light-touch regulation in this area. Goldman Sachs, a well-recognized supporter of buybacks, warns that additional restrictions would send stock prices tumbling and reduce downside protection strategies. Critics on the other hand argue for more restrictions, with some seeking total bans (see Senator Tammy Baldwin’s (D-WI) Reward Work Act) and others recommending more flexible solutions (see Senators Chuck Schumer (D-N.Y.) and Bernie Sanders’ (I-VT) proposal to limit this practice to companies that provide minimum labor benefits, such as a $15 per hour minimum wage). This post summarizes the recent debates and posits that while the public debates focus on questions of “to-ban-or-not-to-ban,” a discussion of the underlying tax policies is a more pressing – and abused – concern.
Reinvestment vs. Redistribution
At the center of this debate lies the question, how should companies spend their excess cash? This basically boils down to whether companies should reinvest their excess cash or distribute it to shareholders, who can then invest it more lucratively elsewhere in the market.
Favoring the former, critics believe reinvestment is essential for innovation, growth, and labor. Sending this cash out of the firm, they say, promotes income inequality as shareholders (including many executives), rather than employees, benefit from corporate profits. One outspoken opponent of buybacks, economist William Lazonick, calls this notion of redistribution “nonsensical.” Good management, he says, should compensate labor or find creative ways to add value to the company, rather than shirk reinvestment in the face of risk. Critics generally converge on these points. Moreover, there is concern that managers’ incentives are misaligned due to stock compensation schemes that benefit from increased stock prices, a common effect of share repurchases. This is because stock prices generally trend with earnings per share (EPS), a figure that increases as profit is spread over fewer shares as a result of buybacks. Instead, opponents believe employees should benefit directly (through compensation) or indirectly (through training and increased opportunities) from the profits they create.
On the other side of the debate, supporters, many of whom are conservatives (although Marco Rubio has spoken out against the practice) and/or investors, warn that ending buybacks would force companies to hold on to cash that they would otherwise distribute when the companies do not have any positive net present value investments to make – a phenomenon that would bring harmful effects. For one, new profitable uses would not necessarily materialize if they did not exist prior to a buyback ban. This might lead firms to either sit on cash or burn through it with little benefit. The argument that companies should increase investment in labor rather than distribute cash in the form of buybacks can also be dangerous, for if a company increases salaries in a good year and bad years follow, that will lead to layoffs and reduced compensation. Furthermore, Professors Jesse M. Fried and Charles C.Y. Wang argue that critics tend to focus on the inequality driven by S&P 500 share repurchases without acknowledging that these companies account for less than 20% of employment. Cash flowing out of these companies can instead go towards smaller growing businesses and generate new employment opportunities, thereby helping to reduce inequality. What’s more, Goldman Sachs research, which indicates that the largest S&P 500 share repurchasers also surpassed market averages in dollars spent on R&D and capital expenditures in 2018, counters the narrative that companies are not investing in internal growth opportunities. Professors Fried and Wang also point to the often-touted statistic that S&P 500 companies are distributing more than 90% of profits to shareholders in the form of dividends and buybacks. However, this figure does not take into account the equity issuances that happen alongside them (which also reduce the impact on EPS figures). Nor does it consider that net income reflects income after R&D and other growth expenses have already been deducted. Taking this into consideration, the net payouts to shareholders actually amount to less than 50% of net income with the remaining revenues going towards growth investment. Furthermore, the idea that executive stock-based compensation schemes are driving decisions to buyback shares is weakened by Goldman’s research noting that companies whose executives are compensated in this way spent the same portion of income on buybacks as those whose are not.
Where to Go from Here?
This post finds that valid criticisms against buybacks are few and far between. However, one area may be ripe for change: tax. Commentators on both sides of the aisle agree that taxes have the potential to motivate buybacks for the wrong reasons. For example, Professor Steven J. Davis, a supporter of buybacks, suggests that companies may use debt to buy back shares in order to reap the tax benefits of debt financing. Opponents share this concern. In addition, there is fear that the disparate tax treatment of dividends versus buybacks advantages wealthy executives and in fact leaves billions of dollars untaxed. The cause of this is as follow: when a company issues dividends, all shareholders are taxed at the income tax rate on the distribution and can offset this tax liability by taking a reduction in their stock basis. However, when a company repurchases shares, only those who sell their shares are taxed on the gain (the difference between sale price and the shareholder’s stock basis) – at the long-term capital gains rate, which tops out at 23.8%. The particularly “advantageous” result occurs when an investor dies. Upon death, the shares are passed onto the shareholder’s heirs, and the basis is stepped up to fair market value. This means, for example, that when Jeff Bezos’ heirs inherit his Amazon equity (Amazon notoriously does not distribute cash through dividends), they will be able to sell those shares immediately and avoid tax liability, as the stepped-up basis will lead to no gain on the sale. The result will be that billions of dollars of CEOs’ gains escape taxation: not ideal.
Too much opposition to share repurchases emanates from outsiders’ desires to tell managers and directors how to run their company. This is not the solution and in fact could have disastrous economic results. Both sides seem to agree that the tax rules surrounding buybacks are less than perfect. Tax reform may shift incentives in a way that satisfies both sides, so why not start there?