Howard Silverblatt, the longtime senior index analyst for S&P Dow Jones Indices, had it right when he said that because the U.S. buyback tax had bipartisan support, there was a good possibility the 1% tax was “only the opening move.”
Indeed, President Joe Biden announced in the State of the Union address Tuesday night that he aimed to quadruple the excise tax on buybacks — which goes into effect this year — to 4%.
“Big corporations and the wealthy were some of the top targets in President Biden’s State of the Union speech," said Mark Everson, vice chairman of alliantgroup and a former IRS commissioner. "Hitting stock repurchases strikes me as a proposal that may very well resonate enough to be enacted. It is more modest and less controversial than a wealth tax — and easy enough to understand — but also appeals to those who are wary of Wall Street and the influence of big business.”
According to Sliverblatt, some companies would likely start to shift some buyback spending to dividend payments if the tax on repurchases reaches just 2.5%. But that would still be returning profits to shareholders. A poll by CNBC found that over half (55%) of U.S. CFOs said a 2% stock buyback tax would cause their company to buy back fewer of their own shares.
Biden says taxing buybacks removes a “distortion” in the tax system between buybacks and dividends — the two major ways publicly held companies return profits to shareholders. Dividends are taxed as the investor’s income; buybacks aren’t taxed directly.
Discouraging the practice, the White House and some members of Congress believe, will force CFOs to allot the cash to “long-term investments” and spend on infrastructure, technology innovation, and, in the case of "Big Oil," as Biden noted, domestic production.
As any CFO would argue, however, C-suites and boards of directors already consider these investments before buying back stock, or at least the smart ones do.
“Studies find that buybacks occur when growth opportunities are poor and when companies have excess capital,” wrote Alex Edmans of the London Business School in a 2019 paper. “So companies make investment decisions first and buy back stock out of surplus cash, rather than repurchasing shares first and investing only out of the scraps left over.”
Good and Bad Investment
As the chart above (Share Buybacks vs Dividends) suggests, while buyback dollar volumes have grown significantly in the last four years, quarterly totals for S&P 500 companies are volatile. That suggests CEOs and CFOs are discerning between good and bad investment opportunities as well as whether a stock buyback will produce more value (earn a higher return) than an alternative investment, to paraphrase Edmans. In uncertain economic periods, companies may also limit distributions to maintain maximum financial flexibility.
The bulk of share buyback dollars come from very large companies with heaps of cash on their balance sheets— the top companies accounted for 49% of the $211 billion in stock buybacks in the third quarter of last year (see table below, Large Stock Buybacks, S&P 500). Even after its $5.6 billion in buybacks in that quarter, Microsoft still had nearly $100 billion on its balance sheet. And, it invested nearly $7 billion in capital expenditures and acquisitions.
The Economic Function
Very large companies distributing excess capital to investors because they have fewer profitable investment opportunities is “a critical economic function,” Gregory Milano, CEO and managing partner of Fortuna Advisors, has argued on CFO. These investors then invest in “the next generation of Apples and Amazons,” companies with better growth prospects. (Milano’s firm produces an annual Buyback ROI report.)
Of course, share buybacks are a qualified good. Some companies execute them poorly, buying when their share prices are too high. That suggests they may not be applying the same discipline as with any other investment to ensure they are optimizing the return they earn, according to Milano. And they do boost earnings, causing some experts to dub them “financial engineering.” And many C-suite executives do wind up profiting from the practice.
But those two facts just mean companies have to get better at execution and be more disciplined. In the past, Milano has suggested companies “don’t use an incentive-compensation measurement approach that rewards financially engineered EPS growth.” In addition, CFOs should be careful not to “set thresholds for organic investment too high, as this will lead to less organic investment and more share repurchases.”
In the meantime, higher interest rates could put more pressure on C-suites to repurchase shares, wrote Milano in the 2022 Buyback ROI report, because they tend to increase the hurdle rates for investments. Suppressing buybacks would just increase the nonproductive cash on balance sheets.