Stock Buybacks Are Popular, The Inflation Reduction Act Could Change That

The Inflation Reduction Act passed by Senate over the weekend, could reduce corporate share buyback activity However, it must still pass the House. The measure as drafted, includes a 1% tax on corporate buybacks for most publicly-listed companies. It may prompt companies to focus more on dividends, rather than share repurchases, starting in 2023.

The plan includes exceptions for REITs; certain financial firms; buybacks that compensate for stock issuance to employees; and buybacks of under a million dollars. Still even with these caveats, most large listed corporations would pay some tax on share repurchases when they didn’t before. That may prompt some corporations to change plans.

Substituting Dividends For Buybacks

Companies have a choice in how they return money to shareholders. Buybacks and dividends are the two main options. However, buybacks get a lot more criticism from politicians. Senate Majority Leader Chuck Schumer (D-N.Y.), a Democrat, recently said “I hate stock buybacks… I think they are one of the most self-serving things that corporate America does.” This idea has bipartisan support. Senator Marco Rubio (R-Fla.) , a Republican, tweeted in 2018, “When corporation uses profits for stock buy back it’s deciding that returning capital to shareholders is better for business than investing in their products or workers”

The negative perspective is that buybacks misdirect money that companies should be investing. It’s unclear why dividends, as a very similar way to return money to investors, don’t also incur a similar criticism from politicians, but they tend not to. Of course, dividends are often taxed, but so too are the capital gains that can result from share buybacks.

Academic Evidence

In contrast to the views of politicians, academic evidence does not seem to support the view that share repurchases hinder investment. Research from the investment firm AQR found that buybacks do not reduce corporate investment. In addition, further research makes the point that 95% of funds returned to shareholders through buybacks are then immediately reinvested elsewhere in the stock market. So buybacks don’t appear to shrink necessary investment in the economy, even if they did so at the company level, which again, evidence suggests they don’t.

However, some do see general flaws in the U.S. tax code around how stock price appreciation, perhaps boosted by buybacks, may not be sufficiently taxed relative to other sources of income, both in the cases of wealthy company founders or with offshore tax-havens holding stock portfolios. Taxing buybacks doesn’t necessarily resolve these potential issues with the tax code, but some view it as a move in the right direction.

Executive Compensation

The measure may also have an indirect impact on executive compensation. Often CEOs are paid, in part, on increasing the stock price of their company. Stock buybacks help that to some degree, as its a way of distributing profits that may tend to increase a company’s share price as the share count declines.

In contrast, dividends though similar, can tend to lower a company’s share price as cash on the balance sheet is handed out to shareholders. In this case, the share price can fall by the amount of the dividends payment. Dividends can make shareholders just as wealthy as buybacks, but may not boost the stock price as much as a buyback would. So perhaps the new tax measure will have implications for executive pay.

Market Reaction

How should we expect the market to react to this? To the extent that corporations pay slightly more tax on share repurchases, stock prices would be expected to decline slightly from this measure. This would happen as a slightly greater share of profits goes to the U.S. government because of this new tax, and less goes to shareholders.

However, corporations can offset the impact, and effectively pay less tax or avoid it entirely, by increasing dividends relative to share repurchases. This is possible because the two methods of returning money to shareholders are close substitutes.

Corporations are generally pretty savvy when it comes to making financial trade-offs, so a reduction in buy backs may well be expected and dividends may correspondingly increase.

Furthermore, the 1% tax on share repurchases is small in absolute terms. Therefore, it is unlikely that the stock market will see big moves based on this specific proposal. But do look out for larger dividend payments and fewer buybacks in 2023 if this measure becomes law as many expect.