Stock Buybacks Are Not the Enemy

SMITH BRAIN TRUST –  Stock buybacks have found themselves in various crosshairs of late, and it’s got Maryland Smith’s David Kass shaking his head.

First there was a New York Times op-ed from U.S. senators Charles Schumer of New York, a Democrat, and Bernie Sanders of Vermont, an Independent, suggesting new legislation that would stop a corporation from buying back its own shares unless it first invests in workers and communities, “including things like paying all workers at least $15 an hour, providing seven days of paid sick leave, and offering decent pensions and more reliable health benefits.”

Then came a series of tweets from Senator Marco Rubio of Florida, a Republican, saying he would soon introduce legislation that would change the way corporate buybacks are taxed, in an effort to boost wages, create jobs and spark corporate reinvestment. “Right now don’t have a ‘free market.’ We have tax code which engineers economy in favor of inflating prices of shares at the expense of future productivity & job creation,” he tweeted.

Kass says the Schumer-Sanders proposal is legislative overreach, while Rubio’s idea needs to be clarified. “Tax buybacks like dividends? Currently, qualified dividends, such as those paid on corporate stocks, are taxed at long term capital gains rates which are lower than ordinary income tax rates.”

Corporate buybacks are a form of returning capital to shareholders and often result from companies not having good investment opportunities, Kass says. These funds, he says, are then primarily reinvested in companies with better investment opportunities that boost the economy and create more jobs.

When a company buys back shares, it typically will only buy back a small number of shares – say 5 percent of its shares over a one year period. Most shareholders won’t be directly affected by the buyback, except for the small benefit they might realize from the rise in the share price as the number of outstanding shares are reduced and the resulting earnings per share increase. “If they are buying it back from you and you have a capital gain, and you held your shares for more than a year, then the maximum tax rate is 20 percent. If you owned the shares for less than a year, then you would be taxed at your ordinary income tax rate,” Kass says.

Sens. Schumer and Sanders, meanwhile, take aim at both buybacks and dividends, charging that corporate boardrooms in recent decades have become obsessed with maximizing shareholder value, even at the expense of workers and reinvestment that would ensure the long-term survival of the firm. They say the drive to satisfy shareholders has helped foster the most pronounced income inequality the country has seen in decades.

And it’s not just these three politicians. The current buyback boom has raised eyebrows in other circles as well, with many questioning whether there are better uses for corporate cash. Last year saw a record amount of share buybacks. And some analysts are predicting another big year.

What the calls from these three senators have in common is this, Kass says: They tap into the rising popular concern for the increasing income inequality and the widening wealth disparities in America.

Kass says, “I can understand the political attraction to 99 percent of the population of taxing the top 1 percent.”

After the so-called blue wave in the midterm elections, and in the wake of the financial crisis, there seems great appetite for taxing the top 1 percent at higher rates.

But this proposed legislation is not the answer, he says. And buybacks are not the problem.

“If the real issue is the minimum wage, or underfunded pensions, or the lack of paid medical leave, or the need for better worker retraining – if those are the real issues – then let’s address those issues directly,” he says. “If there are enough votes in Congress, then these problems can be resolved. Don’t use buybacks as a path to get there.”

Governments frequently use tax policy as a way to create incentives for people and corporations to alter their behavior. And Kass acknowledges that financial incentives can be appropriate and effective.

However, the current proposals, he says, wouldn’t ensure the desired effect. And, further, they would needlessly hamstring corporations.

Corporate buybacks can help improve earnings per share for a corporation, and thereby its share price. An improvement in a company’s share price benefits not only its large stockholders, but also small investors who might hold shares as part of a 401(k), pension plan, mutual fund or exchange-traded fund. The economy often benefits when stocks rise, in part because of what’s known as the wealth effect. That is, when people know their investments are rising in value, they feel more affluent and are more likely to spend money, buy things and go to restaurants – all of which have a stimulative effect on the economy, adding to the gross domestic product and to potential job growth.

If buybacks are restricted or otherwise discouraged, corporate leaders might be more likely to allocate funds in a less efficient manner than in raising wages and benefits for their employees which is the goal of the proposed legislation, Kass says.

“It is generally recognized in finance,” Kass adds, “that buybacks and dividends, add discipline in the corporate boardroom by reducing the amount of free cash flow available which would make it less likely for the CEO to use those funds to over-pay to acquire other companies at a large premium to current market prices and intrinsic value, which would likely result in a reduction of shareholder value.” CEOs have the incentive to increase the size of their companies in part to justify higher compensation, he adds.

“It would be far more effective to legislate increases in employee wages and benefits directly,” Kass says. “We should let corporations choose how to best allocate their capital.”