Let's Reason

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.

 

If you are like me, you like to get up in the morning and, while you sip your coffee or tea, read or hear something good about the human experience and condition.  A new recognition for the town schools, a new medical discovery, a fair election held somewhere in the planet.  Some mornings are full of good news.  But even if you find no news to lift your spirits, don’t feel that things are bad or, even worse, they are heading south.  While you have tried to stay abreast of the world’s everyday developments, you have most likely missed the much bigger stories about the humanity’s advance for better, fairer, and healthier living.  But don’t feel bad about yourself.  Equally ignorant and unaware are some of the most learned and best-positioned-to-know people of the world.

So I want to bring to your attention, in case you have missed it, the most up-lifting and heart-warming book I have read in long time.  It’s titled Factfulness: Ten Reasons We’re Wrong About the World-and Why Things Are Better Than You Think.  It’s written by Hans Rosling, a Swedish medical doctor, who spent his life caring for the underprivileged people of Third World countries and amidst all the deprivation and despair discovered that the human race has been making progress.  Progress that matters for the health, education, and the rights of billions of people.  To spread the good news, he decided to compile the evidence, using mostly United Nations statistics and tell humanity’s tremendous progress to audiences across the globe in more than a thousand presentations.  Unfortunately, this remarkable human being died last year but not before he was able (with the assistance of his son and daughter-in-law) to leave us his findings in this book.

Here is some of the encouraging facts Hans Rosling’s data show about human progress:

1. Sixty percent of girls finish primary school in all low-income countries.
2. The majority of people live in middle-income countries.
3. In the last 20 years the proportion of the world population that lives in extreme poverty has almost halved.
4. The average world life expectancy today is 70 years (by the way it was less than 50 years in the 1950s).
5. The number of deaths per year from natural disasters has decreased to less than half over the past 100 years.
6. Eighty percent of the world’s 1-year old children today have been vaccinated against some disease.
7. Worldwide, 30-year old women have spent 10 years in school, on average, versus 10 years for men – almost a parity.
8. Today, 80% of the world’s population has access to electricity (which is the gateway to modern life).

These statistics are not driven by progress made in developed countries but mostly by progress made in developing countries.  They also suggest the pace of progress is significant over time and although the gap between the developed and developing world is still substantial, it’s not as devastating as usually perceived.  Especially improvements in health, female education, and family planning guarantee that the pace of convergence will accelerate as we move forward.

To his surprise, Rosling discovered that these positive developments were not known to supposedly knowledgeable audiences.  Ironically, the higher the level of education and prominence, the lower the percentage of correct answers (the full set includes more questions and facts).  Rosling attributed this ignorance to a variety of cognitive biases, but the main culprits are (a) the preference of news media to give more coverage to bad news than to positive developments, and (b) the pessimistic view of learned audiences from First World countries about the conditions in Third World countries.

These findings suggest that despite regional conflicts, national antagonisms, and flawed global policies, people are making progress and their living conditions are drawn closer and closer so that the gap between advanced and developing countries is becoming smaller.

So, when you get up in the morning and read or hear some lousy news, remember Hans Rosling’s hopeful and fact-based message: we are making progress.

Note: I will explore some of the implications of Hans Rosling’s findings in future postings.

The launching of this blog coincided with summer and time to take trips and vacation.

So this blog has been quite inactive and will go “dark” until late August.

I wish everybody a cool and pleasant summer.

George

It is the 4^th of July and we are reminded once more of our unalienable rights: Life, Liberty and the pursuit of Happiness.  Indeed, the third right, Happiness seems to epitomize the gist of American life.  How it got in the Declaration of Independence is a fascinating story if we adopt the frequently made assertion that Jefferson was an Epicurean. (See, for example, among other sources the following:

http://newepicurean.com/suggested-reading/thomas-jeffersons-letter-to-william-short-october-31-1819/

Epicurus was an ancient Greek philosopher, born in the island of Samos around 342 BCE, but came to study and then teach in Athens.  He developed interesting theories about pleasure as a goal of life, death, and the role of God(s) in human lives (he believed they were indifferent and left humans alone).

Unfortunately, very little of Epicurus’s original writings survived.  What we know is through third sources.  However, around 50 BCE, a Roman poet Lucretius wrote a six-chapter poem dedicated to Epicurus’s ideas called De Rerum Natura or On the Nature of Things.  This poem did not fare well in the centuries that followed the establishment of Christianity as the only official religion of the Roman Empire.  The main reason was the irreligious ideas of Epicurus (whom we can classify as a Deist) that seem to challenge the notion of a personal God espoused by Christian faith.  Furthermore, in order to discredit Epicurus, during the Middle Ages, writers interpreted Epicurus’s idea of attaining pleasure as a purely hedonistic pursuit totally inconsistent with the anti-materialistic and austere lifestyle advocated by the Church.  As a result, De Rerum Natura of Lucretius and by extension the ideas of Epicurus were eclipsed from western thought.

However, by some sort of divine irony, Poggio Bracciolini, a secretary of Popes, found himself unemployed and did what his hobby dictated him to do: hunt for ancient manuscripts in the monasteries of Europe that in those days happened to be repositories of ancient writings.  Finally, in 1417, Poggio found a copy of Lucretius’s De Rerum Natura in the Abby of Fulda in Germany of which he had made a number of copies.  Thus, incredibly, Lucretius and Epicurus were published again after many centuries in complete obscurity.  Nonetheless, the enduring hostility of the Church toward Epicurean philosophy did not allow this poem to become immediately influential.  As we read in The Swerve of Stephen Greenblatt (from which the details above come) it took a long period before the true message of Epicurus was restored and the Western world regained an appreciation for pleasure as a venerable goal of life.  Far from espousing cheap hedonism, Epicurus taught that humans should seek happiness through a disciplined life that did not equate pleasure with the development of unnecessary wants and their insatiable satisfaction.  Humans should also try to minimize pain.  Certainly, wanting more and more was one way to set up oneself for pain as many of the wants would go unmet.

By Jefferson’s times, Lucretius and Epicurus were already part of the Western Canon.  Indeed, Jefferson owned several copies of On the Nature of Things.  Besides, Jefferson, like many other founding fathers, was a Deist, meaning he did not believe in a personal God that intervenes positively or negatively in the lives of humans.  These facts accord well with the assertion that Jefferson was an Epicurean.

It is not difficult, therefore, to see why “… the pursuit of Happiness” made it into the Declaration of Independence, since Jefferson was its principal writer. In addition to his personal beliefs in favor of Epicureanism, there is also evidence that Jefferson was influenced by John Locke in adding “the pursuit of Happiness.”

What is fascinating in all this is the story of the lost and found poem of a Roman poet, Lucretius, who preserved the ideas of an ancient Greek philosopher whose ideas would have otherwise been lost forever.  And, of course, what made this eventually possible is the personal goal of a Papal secretary who loved to discover lost works of the ancient sages.  History is full of happy coincidences and swerves that enrich our lives and help us understand ourselves so that …. Happiness is not an elusive dream.

So this the 4^th of July, let’s raise our glasses to cheer Epicurus, Lucretius, Poggio, and Jefferson.  And, of course, cheers to the rest of the Founding Fathers and the anonymous American patriots that won the war of independence, thus preserving for us its Declaration as a living document, so we can write stories like this one.

Happy 4^th of July

George

Thanks for joining me!

Good company in a journey makes the way seem shorter. — Izaak Walton