The Misplaced Buyback Tax
On December 27, 2022, the Inflation Reduction Act unleashed a new tax on society. This provision assesses a 1% surcharge on publicly traded corporations buying back at least $1 million of its own stock. President Biden said this is such a good idea, he supports a 4% tax on stock buybacks, saying, “Corporations ought to do the right thing.”
Buybacks are low hanging fruit in an era of populism and desperation for tax revenues. In 2022 corporations spent a record $1.26 trillion buying back their own stock.
However, just because a lot of money was spent buying back shares, does this mean the government should dictate how private businesses allocate profits? Additionally, if we attack buybacks, why stop there? Should the government mandate a certain minimum or maximum dividend level paid by companies?
Considering this, recognize the U.S. is not the only game. Corporations must be competitive across the globe. Even though this tax has been implemented, companies outside the U.S. don’t comply.
The Law of Unintended Consequences will rear its ugly head as markets are highly competitive and capital flows where it is most efficiently utilized.
From this, expect certain outcomes. First, corporate earnings per share will be lower due to the weight of additional taxation. Secondly, U.S. based companies could be encouraged to locate elsewhere in the world. This results in employing fewer Americans and sending more capital outside our nation.
Conceptually, a buyback is no different than buying out a partner. Assume a company has 100 shareholders with each owning one share of stock. If the company makes $500,000 per year, earnings are $5,000 per share.
Assume management finds their own stock to be the most attractive use of net earnings and at the same time 20 shareholders want to cash out. If the company buys back the stock, the company still makes $500,000. However, it is now spread over 80 shares—not 100. As such, earnings per share increase to $6,250.
Given this, share buybacks can enhance value for long-term shareholders and provide cash to those looking to sell. Additionally, unlike a dividend that is taxed twice, the earnings used in share buybacks are only taxed once. As such, a buyback delivers shareholder value with less taxation drag. When a company buys their shares in the open market, no one is forcing this transaction. Everyone is a willing participant.
In running a company, management has a legal obligation to efficiently allocate profits. To deliver capital back to shareholders, a company has a few options.
First, they can declare a cash dividend. Although cash is nice, it suffers from double-taxation and cash received must be reinvested. A company can buy other assets or companies in the open market. Unfortunately, Federal Trade Commission chair, Lena Khan has sued to stop virtually all acquisitions saying they block competition.
This leads us to corporations repurchasing their own shares in the open market. The timing of these buybacks can be much more strategic. Research by the Tax Foundation concluded that businesses buying back their stock tend to perform better than peers over the next several years.
It is unfortunate that governmental leaders call stock buybacks a tool of rich shareholders and greedy corporate executives. Yes, wealthy people own lots of stocks. And modest people benefit via mutual funds that own stocks, as well as retirement plans. We all should own more stocks.
A buyback offers the same percentage increase in value per share for any shareholder. Furthermore, whether buying or selling shares, everyone is a willing participant.
It is interesting to note that buybacks have been championed by long-time Democratic supporters like Warren Buffett and Jamie Dimon.
Capitalism and corporate ownership are far from perfect, but it remains the best system we have. Corporate management must make intelligent investment decisions. This is true whether evaluating personnel, technology, machinery or share buybacks. If management only focuses on one facet, to the detriment of other key components, corporations become less competitive.
Capital allocation remains extremely difficult while the government has not proven to be effective allocators of capital. Knowing this, rarely will more government intervention deliver the desired results—especially without a variety of unintended consequences.
Although this may be pitched as a way to lower inflation or take from the rich, it is just another tax levied across society.