You may have noticed that since before and after passage of the new tax law last December there has been an unusual frequency of news media articles on stock buybacks (also called repurchases). Critics of the tax law have argued that most of the money corporations would save in taxes (especially on taxes of repatriated profits) would be used to distribute cash to shareholders instead of making new investments. Hence, the growth potential of the tax reform would be much lower than that estimated by Congressional Republicans and the Trump administration. The critics’ argument is based on the case of an earlier tax relief on repatriated profits given in the G. W. Bush years which was indeed consumed mostly in stock buybacks. The conservative economists have answered back by saying that tax relief money allocated to stock buybacks is fine because they redistribute money to the economy, and are in fact a good by-product of the new tax law.
Thus, a politically neutral corporate decision, like stock buybacks, has become a political football. Here, I will try to disabuse current opinions about stock buybacks so we can better understand whether they deserve to have an oversized role in the tax law debate.
Point one. Stock dividends do not make shareholders poorer or richer by themselves. In a stock repurchase a corporation simply buys back its own shares. The price paid is what any investor has to pay to execute a trade in the stock exchange. Actually, corporations strive to pay the stock’s fair price and no more. Paying more reduces the price of the remaining outstanding shares held by the non-selling shareholders; and paying less hurts the selling shareholders. Not all shareholders participate in a stock buyback. Those who have confidence in the future of the corporation do not sell while those who are less optimistic are more likely to sell. Selling shareholders simply trade their shares for cash. Before the buyback, their wealth (in relation to the corporation that executes the buyback) is comprised of shares in the corporation. Afterwards, it is comprised of shares (if they still own some) and cash.
Point two. Notwithstanding point one, stock buybacks can indirectly create value. When a corporation buys back its own shares it uses idle cash or borrows money. In either case, the effect is an increase of the size of debt relative to equity. Plenty of empirical evidence shows that rearrangements of debt and equity that increase a firm’s debt-to-equity ratio are viewed by the market as signals of management’s confidence in the firm’s future and result in an uptick of the stock’s price. This stock price increase favors both selling and non-selling shareholders. Even when the intent is not to restructure the firm’s liabilities (i.e., debt and equity), distributing idle cash the firm cannot invest profitably is better than keeping it within the firm earning a sub-optimal rate of return. Another motive with strong empirical evidence is that stock buybacks are undertaken when managers believe the stock is underpriced. Because of the positive signal described above, the stock repurchase restores the market’s confidence and the price goes up. Despite these academic (and empirically supported) hypotheses, the news media keeps repeating that the price uptick is due to reduced supply of shares. Academics call this the price pressure hypothesis; in the case of buybacks, though, it has not received any appreciable currency in academia. Besides, price changes due to temporary disturbances of demand and supply are just that, ephemeral.
Point three. Taxes do affect the decision to execute a stock buyback. The alternative and traditional way to distribute corporate money is to pay dividends. Corporations favor one distribution method over the other depending on the tax rates individuals have to pay respectively for capital gains (that may result from selling shares in a stock buyback) and ordinary income (like dividends). If capital gains are taxed at a lower rate than dividends, shareholders prefer to receive cash through a stock buyback. The new tax law left the tax rates on long-term capital gains unchanged while it lowered the tax rates on regular income (including dividends). As a result, stock buybacks, if anything, became a bit less attractive to shareholders than dividends under the new tax law.
Nonetheless, the corporate tax savings due to the new law made stock buybacks more likely because they put additional cash in the firms’ hands, money many firms may not be able to invest profitably. In that case, it is economically optimal that firms distribute the excess funds to shareholders and let them find ways to allocate these funds to other (presumably better) investments or to consumption. And this is what is happening. The Wall Street Journal has reported that by this August the volume of stock buybacks had already surpassed the record volume of stock buybacks (since 2012) recorded for the whole year of 2016. Therefore, we can safely predict that the critics’ expectation that the bulk of tax savings would be taken up by stock buybacks (as in the early 2000s) was valid. Some news media articles refer to the distribution of the tax savings to shareholders as if it is the wrong thing to do. But let’s remember that profits left after the payment of taxes belong to the shareholders – new tax law or not. It betrays poor understanding of how business works to expect firms to share the higher after-tax profits with workers. If the architects of the tax law wanted part of the corporate tax savings to go to worattain such an outcome. But they didn’t, despite the warnings of economists and business experts that stock buybacks would consume a large part of the tax savings. Therefore, the writers of the new tax law are to blame, not the corporations.
Point four. The fact that the new tax law has unleashed a wave of stock buybacks across corporations may not be good news for the sustainability of economic growth in the US. This point seems to have escaped the attention of conservative economists. Although a stock buyback that distributes excess funds is a value-added decision when undertaken by an individual firm, a tsunami of stock buybacks across corporate America may signify that executives as a whole are not confident the current higher than usual growth rates are likely to continue. Hence, they distribute the tax windfalls to shareholders for better use. The counterargument to this pessimistic interpretation of the high volume of stock buybacks is that executives are instead confident and believe they don’t need as much equity to support their firms’ operations. That is, strong future growth will generate the funds to enable businesses to support their relatively high indebtedness. Time will tell.
Point five. Massive stock buybacks have the potential to hurt the overall stock market. The reason is that, if executed at a large scale, they remove a lot of shares from the public markets and leave investors starving for shares. Fewer shares prevent all shareholders from forming the type of portfolios they like in terms of risk and return. Also trading costs go up as the stock market becomes less liquid. We must add that the number of publicly traded stocks has declined from around 7,000 in 1995 to less than 4,000 by August of this year. At the same time the number of listings of new stocks through Initial Public Offerings (IPOs) has also trended lower. Fewer public stocks along with fewer shares available from the remaining stocks are a sign of decline of the public capital markets. Conservative economists who are market enthusiasts par excellence must loathe these developments. I find it, therefore, puzzling when they sugarcoat the massive wave of stock buybacks because they feel the need to defend the new tax law.
Point six. Conservative economists have asked: “What’s wrong if corporations are left with more money because of lower taxes which they then pass through buybacks on to their shareholders, that is, back into the economy?” Firms with growth potential will use the excess cash to make investments. Others with no such potential will distribute (as we currently see) the excess cash to shareholders. But because it is richer Americans who hold most of the stocks and, hence, will receive most of the money from stock repurchases, the impact of the redistributed excess money through stock buybacks cannot have the save impact on consumption and economic growth. Rich investors are more likely to save the money than consume it since they have a lower propensity to consumption (the economic term that denotes that a lower fraction of one’s income is consumed). Economic growth and economic inequality could have been addressed more effectively if more tax savings had been allocated to middle and lower income families than ending up as funding sources for stock repurchases.
Bottom line. Stock buybacks do not make shareholders really richer as some liberal economists seem to imply. And stock buybacks at the current massive rate are not as good as the conservative economists present them to be. Finally, the unusually high volume of stock buybacks validates the expectation that the corporate tax savings would be used for distribution of corporate wealth to the shareholders than for investments.
CORRECTION: In the previous posting “Human Progress We Fail to Notice” the correct average number of years in school for 30 year old women is 9, not 10 which applies to men. That’s why I wrote women’s education was in near parity with that for men.
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Thank you for the analysis on the share buybacks and the effect of the new tax law. I also thought massive purchasing of any stock and depriving them from the market ordinary investors, because besides increasing the price and cost of shares, creates insecurity on planning on portofolio management.
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