Stock buyback tax is inefficient and could threaten retiree nest eggs

The price tag for the Biden administration’s economic/social agenda has shrunk from the initial $3.5 trillion plan due to strong pushback against various items in the legislation, especially its potential tax increases.

The bill’s size has been cut in half, and many of its contentious provisions – such as the increase in corporate and capital gains tax rates, eliminating step-up in basis and higher income tax rates for high income individuals – will not be part of the new package. But this does not mean the fight over what stays in the bill is any less controversial.

Without having the final details on what exactly is on the negotiation table, it is hard to judge the bill’s potential impact on the U.S. economy. But one thing for certain is that many of the remaining provisions target corporations and high-income individuals, and despite the best efforts of economists, some policymakers believe that these provisions will impact only the targeted groups.

Let’s consider the news around a proposed new tax on stock buybacks. In the U.S., within certain parameters described by the law, companies can use their cash reserves to buy their own stock, ultimately raising their stock price. There are multiple business reasons for doing this. But obviously, the current administration sees only one, as the recently released framework “includes a 1% surcharge on corporate stock buybacks, which corporate executives too often use to enrich themselves rather than investing workers and growing their businesses.”

Stock buybacks are a common practice around the world. They are another way for corporations to return value to their shareholders, like paying dividends. In fact, according to a recent S&P analysis, “Since 1997, share repurchases have surpassed cash dividends and become the dominant form of corporate payout in the U.S.” It is a far more complicated balancing act than the goal of “enriching corporate executives.”

Buybacks generally happen when companies have significant amount of cash in their balance sheets and lack potential investment opportunities that could increase the value of the firm over the long term. Business environment plays a key role in this decision. For example, during the height of the COVID-19 crisis, stock buybacks bottomed in the second quarter of 2020.

Many progressive policymakers see buybacks as taking money away from pro-growth investments in capital and workers. Obviously, if that is the case, the long-run financial health of businesses that undertake stock buybacks should reflect this. But according to one recent analysis, during the 2007 to 2016 period of significant buyback activity, investment in businesses increased substantially as well. In fact, the authors of the study conclude “S&P 500 shareholder-payout figures cannot provide much basis for the notion that short-termism has been depriving public firms of needed capital.”

Stock buybacks may also help the overall economy through efficiently functioning markets: Excess capital returns to investors to find a more productive use, and studies show that a large portion of these returns are reinvested in the stock market.    

The negative perception of buybacks is apparent with the proposal to introduce an additional tax, to slow down buyback activity and raise revenues. The administration projects that the proposal would raise around $125 billion over 10 years. But the revenue can come at a much bigger cost since the proposal introduces another inefficiency to the market, by potentially impacting stock market pricing.

It is no secret that the stock market plays a key role in the retirement system. While direct ownership of stocks outside of retirement accounts is not prevalent among lower income individuals, many such individuals hold stock through retirement accounts.

Interestingly, according to the most recent Survey of Consumer Finance, after combining both types of equity holdings, “Ownership rates of corporate equities increased between 2016 and 2019, driven by families in the lower half of the income distribution.”

State pensions also rely on stock market performance to close the funding gap for the viability of their programs. Any policy that distorts company decisions and prevents capital from moving to more productive uses will impact not only the stock market but also the real economy. That will ultimately hurt the nest eggs that many of us rely on for a secure retirement.

This does not mean that there aren’t bad players in the market. But fierce competition in the global market and increased scrutiny through corporate governance is probably keeping these acts at a minimum.

If the goal is to stop the misuse of buybacks for personal gains, regulations could be tightened. If the goal is simply to raise revenues, there are much better and more efficient ways to do that without distorting economic decisions. Unfortunately, as each new proposal is unveiled, we are moving further away from a simple and efficient taxation system.

Pinar Cebi Wilber is executive vice president and chief economist for the American Council for Capital Formation.