The Attack on Share Buybacks

Harry DeAngelo is Professor Emeritus of Finance and Business Economics & Kenneth King Stonier Chair in Business Administration at the University of Southern California Marshall School of Business. This post is based on his recent paper. Related research from the Program on Corporate Governance includes Short-Termism and Capital Flows by Jesse M. Fried and Charles C.Y. Wang (discussed on the Forum here); and Share Repurchases, Equity Issuances, and the Optimal Design of Executive Pay by Jesse M. Fried (discussed on the Forum here).

Corporate share buybacks are under attack, mainly from the political left (e.g., Senators Bernie Sanders, Chuck Schumer, and Elizabeth Warren and President Joe Biden), but also to some degree from the right (e.g., Senator Marco Rubio).  Critics decry the large sums distributed to shareholders via buybacks because that cash could have been used to fund greater investment and, especially, investment that would make workers better off.  They typically portray buybacks as an opportunistic way for managers to bolster their own pay by artificially inflating stock prices and EPS, leaving their firms starved for cash that could have funded larger investment outlays and provided higher wages and ancillary benefits for workers.  The proposed “remedy” is to impose higher taxes on buybacks, and possibly to allow a firm to repurchase its shares only if it makes investments that satisfy specific worker-friendly criteria (to be spelled out in federal legislation).

The 2022 adoption of a 1% corporate tax on share buybacks takes a small step in this direction, with the following justification offered by Senate Majority Leader Chuck Schumer:

“I hate stock buybacks.  I think they are one of the most self-serving things that corporate America does.  Instead of investing in workers and in training and in research and in equipment, they simply – they don’t do a thing to make their company better….”

https://www.politico.com/news/2022/08/05/sinema-excise-tax-schumer-00050132

The new 1% tax is a small addition to the capital-gains tax on buybacks, and its direct impact is likely to be minor.  However, it may nontheless be significant if it turns out to be the first step in a political process that amplifies the attack on buybacks and results in a markedly larger tax increase.

This paper is motivated by the prospect of such an amplified attack on share buybacks.  The paper identifies some important factors that have been missed by critics, but that should be considered in any decision to increase significantly the tax penalty on buybacks.

The analysis indicates that critics’ strategy will backfire at growth-stage firms, which will invest less, not more, because an increase in the tax on payouts will impede the supply of equity infusions.  At mature firms that are generating ample free cash flow, the strategy will almost surely not induce managers to adopt the (unattractive-for-shareholders) real investments that critics desire.

The problem for critics is that their strategy of seeking to punish and thereby deter buybacks reflects two serious misunderstandings about textbook-level finance principles.

The first misunderstanding is the failure to recognize the role that payouts to shareholders play in the process through which firms raise funds for investment to create (private and social) value.  Rational investors supply infusions of capital to a firm only to the extent that they expect the firm to make future after-tax distributions at least as great in present-value terms as the infusions (where present values include adjustments for the uncertainty/risk, timing, and taxation of those distributions).  Tax regimes that increase the penalties on buybacks will reduce the future net-of-tax distribution amounts expected to be received by shareholders.  That, in turn, will reduce the earlier flow of capital into firms, leading to lower investment, employment levels, and total wage payments – especially by growth-stage firms, which loom large on the demand side of the market for equity infusions.  These consequences are the polar opposite of what critics hope to induce by deterring buybacks.

The strategy will almost surely fail at firms that are generating abundant free cash flow (FCF) and are therefore unlikely to need much in the way of equity infusions.  To see why, note first that, if managers are opportunistic, as the critics’ narrative maintains they are, then they will likely use higher taxes on payouts as an excuse to justify greater retention of cash, which they will proceed to spend in self-interested ways.  Critics will thus have created “cover” for opportunistic managers to deflect attempts by activist investors to force greater payouts to avoid FCF waste.  In this managerial opportunism scenario, penalizing buybacks with a tax increase will not foster the types of investments that buyback critics desire, and will instead give managers greater ability to warp investment policy to benefit themselves.

If managers are not opportunistic, imposing higher taxes on payouts will not induce them to make investments they judge to be seriously unattractive for shareholders.  The key here is the (simple textbook-level) conceptual distinction between retaining FCF and investing cash that has been retained in the firm.

Importantly, there are many ways to deploy retained cash that do not involve either investment in real projects generally or real projects that make workers better off (which is what buyback critics hope to achieve).  Managers always have the option to avoid real projects they judge to be undesirable by investing incremental retained cash in a wide variety of financial assets, including securities issued by intermediaries, governments, and other operating firms.

The failure to recognize the existence of this option is the second misunderstanding of textbook-level finance principles that underlies the flawed strategy of buyback critics.

The importance of this option is that it effectively places a high lower bound on the value of real projects that managers would be willing to adopt if faced with tax-based incentives to retain more cash.

The implication here: Although increasing the tax on payouts will plausibly induce more cash retention, that by itself is not sufficient to induce managers to invest the incremental retention in ways that critics deem desirable, but managers view as clearly making shareholders worse off.

Given the critics’ objective of encouraging firms to invest more and in ways that improve the welfare of workers, the right approach is to champion laws that create incentives that directly promote the specific desired behaviors.  The focus on punishing share buybacks per se is counter-productive.

Summary of key points:

  • A misunderstanding of textbook-level finance principles underlies the attack on share buybacks.
  • Critics advocate increasing the tax on buybacks in the hope of inducing firms to invest more and in ways that benefit workers.
  • This strategy will backfire at growth-stage firms, which will invest less, not more, because a payout-tax increase will reduce the supply of equity infusions.
  • At mature firms that are generating ample free cash flow, the strategy will almost surely not induce managers to adopt the (unattractive-for-shareholders) investments that critics desire because managers always have the option to invest retained cash in financial assets rather than real projects.
  • Critics of buybacks should drop the idea of punishing cash payouts to shareholders, and instead focus on making the case for legislation that creates incentives that directly encourage the specific corporate-investment behaviors that they desire.

The full paper is downloadable at:

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4255207

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