Yves here. Even though this article on stock buybacks by Steve Roth, cross posted below after this lenghty introduction, makes an important central point, I believe it is missing the forest for the trees. Roth acts as if stock buybacks are merely an alternative to dividends (or investing or paying workers more). It’s far worse than that. Since the crisis, many companies have been borrowing to buy back stock. And why is that? Duh, because executives have big time incentives to goose the stock price, and stock buybacks have become a socially acceptable way to manipulate share prices.
We have from time to time published the work of William Lazonick, who has made a much more comprehensive critique of stock buybacks, with considerable underlying data. It’s great to see his ideas finally going mainstream with the publication of an op-ed in the New York Times by Chuck Schumer and Bernie Sanders (odd couples like that tell you the tectonic plates are moving), and more important, their plan to introduce legislation to curb buybacks. As they sketched out:
Our bill will prohibit a corporation from buying back its own stock unless it invests in workers and communities first, 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.
In other words, our legislation would set minimum requirements for corporate investment in workers and the long-term strength of the company as a precondition for a corporation entering into a share buyback plan. The goal is to curtail the overreliance on buybacks while also incentivizing the productive investment of corporate capital.
As you’ll see, this is actually a modest proposal, although forcing companies to take care of workers before they engage in share price manipulation is an important reordering of priorities.
By way of contrast, here is the key section of a 2018 post by Lazonick, who also gives credit to the Congresscritters who have been dogging this abuse for some time:
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.
It has hit the point where the biggest buyers of US stocks in aggregate are the companies that once issued them. This is not how a well functioning economy operates.
By Steve Roth, publisher of Evonomics. He is a Seattle-based serial entrepreneur, and a student of economics and evolution. He blogs at Asymptosis, Angry Bear, and Seeking Alpha. Twitter: @asymptosis. Originally published at Evonomics
Bernie Sanders and Chuck Schumer’s New York Times op-ed, “Limit Corporate Stock Buybacks,” has thrown internet gasoline on the buyback debate. The left is waving the flag, and the right is trying to tear it down.
The core Sanders/Schumer argument: buybacks extract money from firms, money that could be used to pay workers more, and fund productive investment (including worker training and upskilling).
The counterargument: how are buybacks any different from dividend distributions that way? Both transfer cash from firms to households. We don’t hear people complaining about dividend distributions stealing money from workers and investment.
That counterargument is absolutely right, even while it’s completely wrong. Because both sides miss the overwhelming effect of stock buybacks (vs dividends). Buybacks are a massive tax dodge for shareholders.
Imagine Megacorp wants to transfer a billion dollars to its shareholders (notably including the huge shareholders in its C suite and on its corporate board). Whether they distribute dividends or buy back shares, either way Megacorp has a billion dollars less on its balance sheet. Its book value drops by $1B.
But what happens on the household, shareholder side? With a dividend distribution it’s simple; households get $1B in taxable dividend income. With a buyback, households that sell shares also receive $1B in cash, but they give up their shares, which obviously have value.
That’s where the (perfectly legal) tax avoidance lies — perhaps best explained by example:
Suppose the average shareholder’s shares were purchased for $20 each. That’s the shareholders’ tax basis. If Megacorp pays $25 a share (for 40M shares), the shareholders who sell have cap gains of $5 a share — $200M in taxable income — versus $1B if the same cash is paid out via dividends.
Dividends and long-term cap gains in the U.S. are currently taxed using the same rates and brackets: 15% if your income is above $38K, 20% if it’s above $425K. If Megacorp chooses a $1B stock buyback, our imagined shareholders pay $40M in taxes (at the 20% rate), versus $200M in taxes on a dividend distribution.
Neither of these has any effect on corporate taxes, by the way. C-corporation profits (as opposed to S corporations and other “pass-throughs”) are taxed at the corporate level, whether they get distributed or not, and no matter which distribution method is used.
There are other important problems with buybacks, mainly having to do with boards’ and C suites’ greater discretion over the timing and amounts of buybacks, and the potential for self-dealing price manipulation. (Contra Schumer and Sanders’ odd bank-shot approach to this problem, we could just repeal Rule 10B-18.)
But the right is right: Buybacks are no more pernicious than dividends in “stealing money” from firms, that could otherwise be used for worker pay and productive investment.
And they’re dead wrong that there’s no difference between the two. Buybacks steal money not so much from corporate wages, but much more obviously and explicitly: from taxes that contribute to our common public purse.
There is another consideration – back when marginal taxes at the highest bracket were much higher, one of the limits of executive compensation was the fact that even if they engaged in such behvaiour, most of this would be taxed away.
It seems then that the solution is:
1. A straight up ban on stock buybacks, as they seem to be mainly an instrument for maximizing executive compensation by boosting EPS and share price, which are common metrics used to pay executives. They also result in debt from buybacks and less capital for actually meaningful investments.
2. The “Carried Interest” loophole should be immediately eliminated. This will also discourage “vulture private equity” as well, a social drain on society.
3. Taxes should be steeply progressive. This is to act as a deterrence against rent seeking. Perhaps the standard deduction could be increased even for ordinary working class citizens. Capital gains should be taxed at a comparable rate to labour or even higher (as the top 10% control 85% of stocks anyways).
4. A special high net worth enforcement unit should be set up in tax collection agencies around the world. This is to identify and catch high net worth individuals who engage in tax evasion and possibly aggressive tax planning as well.
5. Tax incentives should encourage corporations to invest in things that are actually productive, such as R&D, capital expenditures, and employee training. One key issue is that company executives know that share buybacks are the easiest way to maximize executive compensation and that they will often only be there for a few years. Competing through a superior product/service, developing R&D, good corporate culture, etc, is “hard” for executives and may not lead to a return. Plus it is often short term pain, long term gain.
6. Corporate governance clearly needs reform and I think that we may need something far more independent on boards than what is currently there. Often executives have a bias towards voting for high compensation knowing that they will someday face similar boards. They also tend to support management or be appointed to be “yes people” as opposed to be independent.
The biggest issue though is that our society’s rich have no sense of noblesse oblige anymore. Their goal is to maximize their own compensation at society’s expense. Tools like shareholder buybacks and private equity are just a cover for those objectives.
If we want to get fussed over taxes and tax evasion, domestic stock buybacks, capital gains taxes, and dividend taxes seem like small potatoes compared to the games international corporations play to realize their profits in countries that don’t tax them.
Too many donor and other interested parties with domiciles or at least PO Boxes in Jersey, Panama and the United States. :(
I fail to see the monstrous tax dodge because the analysis fails to consider the integral of tax payments over the life of the stock.
Whomever sold the current shareholders their stock at $20 must have paid capital gains on that sale , unless it IPO’d at 20.
So there are effectively two cases. The first is that it IPO’d at 20. In this case, the shareholders put in the first 800M, and it doesn’t seem unfair to tax them only on the additional 200M the company made.
The second is that it IPO’d at zero. Then the total amount of capital gains tax as it changed hands up to $20 (where current shareholders bought it) is on $800M. So again, taxing only $200M doesn’t seem unfair.
For ipo prices between 0 and 20 you just have a combination of the two arguments.
One might conclude that the dividend tax double-taxes early share gains.
Why capital gains tax should be less than income tax makes no sense or obvious fairness. You might want to argue that dividend double-taxation isn’t such a bad thing and effectively compensates for a low capital gains rate.
But the buyback isn’t per se a tax dodge any more than the capital gains tax in the first place. And it would probably be conceptually cleaner just to raise the capital gains rate.
I didn’t address this, and should have. He really is making a mountain out of a molehill.
Only about 1/4 of US stocks are held by taxable investors (the households he mentions). Retirement accounts including public and private pension funds, foundations, endowments, and foreign investors are all tax exempt. So any of them could have been the seller to the taxable household back in the day.
One of the dubious aspects of Borrowing v Shares is that debtors are senior to shareholders if a company files for Bankruptcy.
This borrow-to-purchase shares appears to increase shareholders risk, while enriching senior executives and does noting for the business, such as broaden market, introduce a new product or any other beneficial (good) action.
Morally, I perceive it as an extreme form of insider trading. The buyback is clearly know to company executives, has the intent of increasing share price, and presents a great opportunity for insider bad behavior.
Which was said in this article.
You could argue that dividends get taxed at current rate, whereas capital gains from selling shares taxes at the rate at the time of the sale. Ergo, shareholders can wait for a decrease in capital gains taxes to sell and functionally dodge the taxes they would have paid if they received a dividend. However, it’s still a weak argument as the capital gains rate could easily go up, and/or the value of the stock itself could fall for some other, unrelated reason. Yves’ and Lazonick’s critiques are much more relevant.
This article is addressing stock buybacks, but it’s not fair to then jump to capital gains tax policy as if that’s all there is. Capital gains is more than just stock. It really irritates me that old people selling their farm because they need $$$ for the nursing home/assisted living center should in some eyes pay ordinary income rates on what they have spent literally a lifetime of blood, sweat and tears building as their sole nest egg because they are poor dirt farmers who didn’t have access to employer provided insurance or retirement funds. And before anyone accuses me of falling for propaganda, that’s a scenario I see repeatedly every year anymore.
“employer provided insurance or retirement funds”
They are self-employed just like I am. This falls on me, not anyone else. I can decide to provide myself insurance or retirement funds. If I sell my business, I should pay capital gains.
If my business doesn’t make any money, I’m in the wrong business. That’s my choice.
It’s laudable and important to force companies to properly compensate workers before initiating stock buybacks. This won’t solve he problem of using funds for buybacks instead of capital investments, R&D etc. To accomplish that we also need to un-Bork anti-trust law and actually have companies that are honestly competing with each other.
Thank you, Yves.
It won’t surprise you and the NC community that there’s a debate on this side of the pond, too, as per https://www.theguardian.com/business/2015/aug/05/legal-and-general-boss-backs-andy-haldane-city-short-termism-shareholders, although the debate has gone quiet, perhaps due to the person sparking the debate going a bit quiet and not wanting to further diminish his chances of succeeding the matinee idol from the colonies.
To what extent have stock buybacks enabled corporate managers to leverage income streams in the corporations they ‘manage’ to increase corporate debt through bond issues? What happens to a corporation when it’s revenue streams are impacted by ups-and-downs of the economy? Hasn’t Professor Hudson gone on at length describing the instability such debt creates for a business? Dividends can move up-and-down with revenue streams, but bonds must be paid or there is a corporate cash flow problem. For a small business that means bankruptcy while for large corporate players I think that means takeover and merger further consolidating our monopoly and monopsony bloated Corporations. After all these years of stock buybacks and consolidation how much cash flow remains to leverage?
Given the legal ability of corporate managers to use corporate funds to actively manipulate stock prices for their private benefit, how many of those corporate managers use their ‘omniscience’ to goose their private benefits and just how closely has the SEC been watching for insider trading? Martha Stewart learned her lesson in a show trial for our entertainment, but are we really supposed to believe she is the only person making use of inside knowledge to do a little private stock dealing?
Worry about stock buybacks now? Too little and I fear much too late. How many of our great corporations are little more than Potemkin fronts for hollowed out shells of debt feeding a massive transfer of the wealth our country built over many generations into the hands of the obscenely wealthy?
Our Society gives a special place to business enterprise on the theory that it benefits us all through innovation in products, their production, and distribution, and that business provides a livelihood for our people. Corporations receive disproportionate benefits protecting them from risk in their ventures. Stock buybacks and financial manipulations undermine the creative impetus [such as there were] that once drove corporate management, or more accurately they redirect that ‘creative impetus’ toward schemes for most efficiently looting what past managers built.
From the intro: …”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’.”
Good to see this issue finally gaining some political traction, although it’s difficult at this point to overstate the contribution to the deterioration in the nation’s economy, corporations’ financial and operating strength, social fabric, and ethical values that has occurred as a result of these massive corporate stock buybacks and dividend payouts that have been funded in large part with debt.
Also difficult to separate this issue from the related issue of stock and bond market price manipulation. For anyone who is paying attention, the coordination has been singularly impressive. The late December pivot in prices of junk bonds and low-rated investment grade bonds, that along with leveraged loans are used to fund stock buybacks, is but one example illustrative of the level of control.
That corporate CEOs and their networked boards would use the corporate tax reductions to do stock buybacks and pay out cash dividends was both entirely predictable and IMO an intended outcome that has further contributed to economic, political and social inequality. Bottom line, this issue is truly a poster child for neoliberalism. Including the involvement of large hedge funds, this all reminds me of the bust out schemes in the Sopranos. Should this practice be allowed to continue without restriction, I am concerned that many large corporations will become nothing but empty shells. Arguably that has in some instances already occurred. Citizens United indeed.
Thanks for this! Loved the lengthy introduction! (typo there btw). Great to have these details on why “shareholder value” is a false paradigm.
The payout ratio of dividends to earnings is an important measure to look at for every investor. When that ratio is too high, it means there is a danger that the resources of the company are being depleted. So even investors know that though dividends can be good, too much dividend payment is bad.
This is an issue the left loses their minds on. They fail to see how the system works. Buybacks simply put money in the hands of a different asset class? Why would you think the best user of excess corporate profits would be the business that created those profits. Its better ending up in the investor class that will use it for consumption or investment in smaller enterprises.
If you eliminated the buyback then you would encourage corporate empire building. Truth is most executives are just not that good at expanding their business. A coca cola executive is trained to figure out marketing, production, and distribution of soda water; not figure out how to invest billions in new enterprises. Truth is they would likely invest poorly and waste capital.
It’s also created a bubble in corporate consumption based on the historic rise in capital income, that’s goosed the economy since 2013. That looks to be busting now. Definitely a different kind of recession starting now. Service sector led.
One would have expected the executives to scour the world and their companies internally looking for good investment opportunities.
So these companies are at the optimal investment level in employee training, inventories, plant and facilities, R&D and acquisition of critical intellectual property?
And, miracle of miracles, a great many companies, in concert, decided that their own stock was the best use for their excess funds.
One might have expected a few companies to consider that ANOTHER company’s stock was a good buy and do a wise acquisition.
Quite possibly the executives orchestrating the buyback may be illustrating your point “Truth is they would likely invest poorly and waste capital.” in the very act of doing the stock buyback.
Why would they be more competent when allocating capital for a stock buyback?
Were companies poorly run PRIOR to the Reagan era SEC ruling change (November 1982) that allowed companies to buy their own stock?
Is there (“truth is”) evidence of this waste of corporate funds prior to 1982?
Massive Stock buybacks will not look like a good idea if the company later wants to tap the equity market (when they can’t pile on more debt) and shareholder value decreases as more stock is issued at lower prices (see perhaps General Electric).
One can hear the spin, “We are issuing (selling) more stock to increase shareholder value”.