Taxing corporate stock buybacks is a bad idea

But, to obtain Sinema’s vote, Democrats agreed to drop the so-called “carried interest” tax proposal, which would have taxed as ordinary income the share of profits that partners in private equity firms and hedge funds earn from their businesses, often about a 20% share. Current law will remain in place. The profits earned by private equity managers and hedge fund operators, so long as the profits are held for three years, will be taxed at capital gains rates, typically 20%, not the normal 37% rate on individual income for taxpayers in the highest bracket.

Sinema also demanded and received a carve-out for accelerated depreciation from the 15% minimum tax on large corporations. Manufacturers who invest will continue to enjoy the benefits of depreciating capital investments at a faster pace than the true economic life of the capital asset. Accelerated depreciation improves cash flow and reduces the economic cost of new investment. Yet, to make up for the loss of potential revenues from no change to carried interest and from the carve-out for accelerated depreciation, Democrats plan to impose a 1% excise tax on corporate buybacks. This would be a clear tax on capital and, consequently, a terrible policy.

Capital is scarce by definition. To reduce capital is to starve the economy of the funds necessary for investment and innovation in the overall economy. The nation is poorer when capital is taxed. The uninformed say buybacks are just a mechanism to raise share prices and to increase compensation for senior executives.

But that is not true. Capital returned to shareholders by buybacks is recycled through the economy. The selling shareholder may invest in a different company, a new business, or a venture capital operation. The capital continues to exist and work the magic of private investment.

Aswath Damodaran, a professor at NYU’s Stern School, is recognized as the “dean of corporate valuation” by Wall Street. He has written that “buybacks can increase value, if they lower the cost of capital and create a tax benefit that exceeds expected bankruptcy costs, and can increase stock prices for non-tendering stockholders, if the stock is under valued.”

Or consider Alex Edmans of the London Business School. Edmans writes, “The UK government commissioned PWC and me to study the alleged misuse of share buybacks in the UK. Over 2007-2017, we found that not a single FTSE 350 firm used buybacks to hit an [earnings per share] target that it would have otherwise missed.” Moreover, scholars at Vanderbilt University find that stock buybacks have an overlooked beneficial effect on stock liquidity (the ability for quick and low-impact transactions) and stock volatility (degree of price movement). Stock buybacks improve market liquidity, which reduces volatility and improves transaction prices.

We should also note that stock buybacks generate an economically large benefit for retail investors. Since 2004, buybacks have saved retail investors $2.1–4.2 billion in transaction and price impact costs. Managers of companies increase buybacks when volatility and uncertainty are higher, consequently improving the efficiency of market pricing. And public companies often step into the market when a large seller emerges and mitigate the impact of the decision to sell by a large shareholder. Volatility and uncertainty are reduced.

For the retail investor, buybacks lower trading costs and reduce downside risk. Buybacks efficiently reallocate capital, as well as reduce risk and improve price discovery.

Taxing buybacks is bad policy. Such a policy would reduce long-term growth and hurt retail investors. What is the thought process?

James Rogan is a former foreign service officer who later worked in finance and law for 30 years. He writes a daily note on finance and the economy, politics, sociology, and criminal justice.