The Unsung Upside of Share Repurchases
Stock repurchases by issuing corporations have always been controversial. But they have become even more so recently because of the perception that the excess funds used to finance buybacks have come from tax cuts and other sources (such as government bailouts) that were intended to stimulate reinvestment or enhance wages and benefits for workers. As a result, critics have proposed that tax law be amended to discourage buybacks (and possibly dividends as well) on the theory that the benefits of such distributions go mostly to executives (who are compensated in large part with equity) and to already wealthy stockholders.
The controversy is fueled in part by the sheer size of distributions, which have equaled about 93 percent of operating earnings among S&P 500 companies in the aggregate (including both dividends and repurchases) over the last decade. The fuss is further magnified by the suspicion that repurchases must be tax-motivated because (of course) corporations do most of what they do because of the tax consequences.
As I explain in a forthcoming article, the crucial fact missed by the critics is that almost all (about 96 percent) of the funds distributed by repurchases are reinvested by recipient stockholders in the shares of other public companies. Indeed, stockholders are effectively required to reinvest in order to generate the higher returns that one expects from equity. Those who fail to reinvest do no better than bondholders. But unless some significant number of investors disinvest—take the money and run—it would seem that the market would amount to a massive and self-propelled Ponzi scheme in which investors have fooled themselves by reinvesting the funds they receive back into existing firms at ever higher stock prices (for the most part).
Thus, there must be a supply of new shares in which the proceeds of buybacks can be invested. Indeed, most of the funds distributed by big public companies ultimately go (1) to newly public companies or existing public companies that issue additional shares or (2) to buy stock issued by existing public companies to acquire private companies (whose sellers sell the shares with which they are paid). And some of the money goes (3) to control for dilution caused by shares issued in connection with equity compensation. As I show in my piece—based on FRB data and some serious back-of-the-envelope calculations—this process accounts for at least 60 percent of the funds distributed by S&P 500 companies. The remainder is reinvested in other public companies (and presumably private companies) in a continuous process that redistributes value (and thus ultimately capital) among firms according to the prospects of each.
Moreover, this process results in a chain reaction of sales and purchases by investors that has the effect of multiplying the taxes paid. Given that 96 percent of such funds are reinvested (based on data derived from the behavior of mutual fund investors), one might expect every dollar distributed to be reinvested as many as 25 times, thus increasing the taxes paid by investors. To be sure, this calculation assumes that distributed funds change hands many times before coming to rest in newly issued shares, and it ignores the fact that investors are free to time investments so as to offset gains with losses. But the point is that even if the market is akin to a game of musical chairs in which one in 25 investors must disinvest, the fisc must come out way ahead.
Finally, the proverbial elephant in the room is that more than 75 percent of all equities are held in tax-deferred accounts such as pension plans, 401(k) or 403(b) accounts, and IRAs. (And that is not to mention non-profit organizations such as foundations and endowments). For these stockholders, it makes no difference how we tax distributions because they pay no tax anyway—at least until cash is withdrawn by the owner of the account or the owner’s heirs. Thus, the fact that repurchases permit some investors to defer tax until they choose to sell their stock makes no difference to most investors. Moreover, when such investors do withdraw cash from their accounts, it is taxed at ordinary income rates (up to 37 percent at the federal level) irrespective of whether it came from an employer contribution or from a voluntary salary reduction or from return on investment (which would have been taxed at 20 percent but for being held in a tax deferred account). In other words, the government gets a pretty good deal—one that is about to pay off big-time now that Boomers are well into retirement age. The bottom line is that, although the government must wait for its money, most investment returns end up taxed as ordinary income.
In the end, the idea that business and investment decisions are mostly tax-driven obscures the subtler—and more powerful—descriptions and explanations of how the world works. So it is quite wrong to assert either that stock buybacks avoid taxes or that they result in more consumption by already wealthy stockholders. Rather, the process effectively delegates the question of where to reinvest the money to investors collectively—the market—and away from the companies that generate the return (which companies would undoubtedly tend to reinvest mechanically in their own lines of business). Indeed, it borders on miraculous that the system has evolved to induce management of the largest corporations to distribute almost all of the profits they generate rather than to retain them, as was the practice as recently as the early 1980s.
In short, although efforts to address wealth and income inequality are laudable, the critics misunderstand how share repurchases work and their proposals would probably make matters worse. The real worry is that we might cause companies to reinvest in underperforming acquisitions or simply to retain excess cash for no reason at all.
Richard A Booth is the Martin McGinn Chair in Business Law at Villanova University’s Charles Widger School of Law.
This post first appeared on the Columbia Law School Blue Sky blog.
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