By William Lazonick, Professor of Economics, University of Massachusetts Lowell; President, The Academic-Industry Research Network. Originally published at The Hill; cross posted from the Institute for New Economic Thinking website
Workers, innovation, and productivity all suffer when corporations spend their new U.S. tax breaks on stock buybacks.
The deceptively named Tax Cut and Jobs Act slashes the corporate tax rate from 35 percent to 21 percent on the theory that companies will use the extra after-tax profits to make productive investments that will create jobs for Americans. Yet it is clear that instead of helping to rebuild the vanishing middle class, corporate executives will funnel the tax savings to already-rich shareholders through stock buybacks and cash dividends, increasing their take from the stock market. As a result, the nation’s rampantly unequal income distribution will only become worse.
Corporate executives are not being secretive about what they intend to do with the corporate tax breaks. With Trump’s chief economic adviser Gary Cohn on stage at the annual Wall Street Journal CEO Council last November, a moderator asked the room full of executives, “If the tax reform bill goes through, do you plan to increase your company’s capital investment, show of hands?” When only a very few CEOs tentatively raised their hands, Cohn asked, “Why aren’t the other hands up?” Subsequent interviews made clear that, among the CEOs, it was already a foregone conclusion that the tax breaks would end up as buybacks and dividends.
For the Republican corporate tax cut to result in job creation, Congress must follow it up with legislation to rein in these distributions to shareholders. There is a straightforward and practical way to accomplish this objective: Congress should ban corporations from doing stock buybacks, more formally known as open-market stock repurchases. As if more evidence were needed, here are three reasons to expect that corporations will use the Republican tax break to do stock buybacks.
First, the stock-based compensation of senior executives incentivizes them to do distributions to shareholders. Annual mean remuneration of CEOs of the same 475 companies listed on the S&P 500 from 2007 through 2016 ranged from $9.4 million in 2009, when the stock market was in the dumps, to $20.1 million in 2015, when the stock market was booming. The vast majority of this total remuneration, ranging from 53 percent in 2009 to 77 percent in 2015, was in the form of realized gains from stock-based options and awards.
Second, for more than three decades, executives of major U.S. corporations have preached, conveniently masking their self-interest, that the paramount responsibility of their companies is to “create value” for shareholders. Most recently, from 2007 through 2016, stock repurchases by 461 companies on listed on the S&P 500 totaled $4 trillion, equal to 54 percent of profits. In addition, these companies declared $2.9 trillion in dividends, which were 39 percent of profits. Indeed, top corporate executives are often willing to incur debt, lay off employees, cut wages, sell assets, and eat into cash reserves to “maximize shareholder value.”
Third, in recent years hedge fund activists have ramped up the pressure on companies to do buybacks. With their immense war chests of billions of dollars of assets under management, these corporate predators have used the proxy voting system, “wolfpack” collaboration among hedge funds, and direct engagement with management, which was once illegal, to participate in the looting of the U.S. business corporation.
Repurchases done on the open market, which constitute the vast majority of all buybacks, are nothing but manipulation of the stock market. So why are companies allowed to do them? Because of the 1980 election of Ronald Reagan as president on a platform of market deregulation. In November 1982, after Reagan had appointed Wall Street banker John Shad as chairman of the Securities and Exchange Commission (SEC), the agency adopted Rule 10b-18, which permits a company to do buybacks that can amount to hundreds of millions of dollars per day, trading day after trading day, without fear of being charged with stock-price manipulation. Rule 10b-18, which remains in force 35 years later, is a license to loot the U.S. business corporation.
The argument for rescinding Rule 10b-18 is overwhelming. As research I’ve done with the Institute for New Economic Thinking documents, buybacks wreak immense damage on households, companies, and the economy. The profits that major corporations reinvest in productive capabilities form the foundation for a prosperous middle class. Buybacks deprive companies of that investment capital, instead serving as a prime mode of making the richest households richer while eroding middle-class employment opportunities.
Moreover, the justification for buybacks rests on the faulty ideology that, for the sake of economic efficiency, companies should be run to “maximize shareholder value.” Agency theory, the academic thinking that underpins this ideology, assumes that only shareholders take the risk of investing in the productive capabilities of companies. In fact, public shareholders do not as a rule provide financial capital to companies. They simply buy and sell outstanding shares. The true investors in productive capabilities are “households as workers,” whose skills and efforts generate the company’s innovative products, and “households as taxpayers,” who devote a portion of their incomes to fund public investments in infrastructure and knowledge that companies need to be competitive.
Finally, the insidious Rule 10b-18 that for more than three decades has encouraged massive stock-market manipulation is just an ill-considered SEC regulation, adopted as part of Reagan “voodoo economics.” The justification for Rule 10b-18 has never been debated, nor have its provisions been legislated, by Congress. That may, however, finally be changing. A number of U.S. senators, including Elizabeth Warren (D-Mass.), Bernie Sanders (I-Vt.), Brian Schatz (D-Hawaii), and Cory Booker(D-N.J.), have voiced criticisms of buybacks, as has former Vice President Joseph Biden.
The most persistent challenge to this corrupt practice has come from Sen. Tammy Baldwin (D-Wis.), who in 2015 wrote two highly critical letters to former SEC Chairman Mary Jo White, and who has recently challenged the prescription drug lobby group PhRMA to reconcile its claim that the pharmaceutical companies need high drug prices to fund research and development with the fact that the major companies spend virtually all their profits on buybacks and dividends.
Currently, Baldwin has letters outstanding to the two nominees for SEC commissioner, Democrat Robert Jackson and Republican Hester Peirce, demanding that they make clear their positions on buybacks before their appointments are approved. In these letters, Baldwin observes that today our financial markets are “primarily used to distribute cash to shareholders. Ever more aggressive investors demand share buybacks and their allies in executive suites — their compensation increasingly dependent on stock price — are all too happy to oblige.”
Many more of the nation’s lawmakers must join this fight for America’s future by putting an end to the predatory corporate behavior of which buybacks are a significant part. A ban on stock buybacks would be a giant step in resurrecting corporate employment as a foundation for a prosperous and expanding middle class.