Are Buyback Taxes a Policy Mistake?
Buybacks: Much debated, increasingly in-focus and – perhaps – soon to be subject to new taxes. Corporate stock buybacks have been all over the financial news recently, capturing the attention of investors and decision-makers alike. Recently, President Biden highlighted a proposal in the State of the Union address to quadruple (to 4%) the 1% tax on buybacks imposed last year by the Inflation Reduction Act. We also saw Warren Buffet share an uncharacteristically salty quip in his annual letter:
"When you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue (characters that are not mutually exclusive)."
And in recent days, U.S. Commerce Secretary Gina Raimondo said companies that voluntarily give up buybacks for five years will be treated preferentially when the agency distributes $52 billion under the CHIPS and Science Act.
Like many of the negative narratives around finance, skepticism of and criticism directed at buybacks has some basis in fact. There is no shortage of examples where buybacks have diminished, rather than enhanced, shareholder value. As Buffett has acknowledged, "when a company overpays for repurchases, the continuing shareholders lose." Furthermore, short-sighted executives using buybacks solely to engineer a boost in EPS to meet compensation targets is harmful to shareholders.
But as columnist Peter Coy put it in the New York Times this week, "It's good for companies to give back money to their shareholders when they don't see productive uses for it. Are buybacks always good? No. Are they always bad? Also no."
Regrettably, policy proposals to discourage buybacks are surfacing at a time when cash flow distributed by companies to their shareholders is becoming, and will continue to be, an increasingly important part of the return stock market participants receive from investing their capital in productive enterprises. As macro research firm Strategas, a Baird company, wrote in a recent note, "During a period in which multiple expansion may be difficult to generate, shareholder yield – the combination of dividends and share buybacks as a percentage of net income – will likely be a significant source of the total return equity investors may expect to receive in the coming years."
We're talking big numbers. Even with dividends and buyback proceeds exceeding $1.5 trillion in 2022, cash on corporate balance sheets is still well above the long-term average – 5.3% vs. 3.8%, according to Strategas. In other words, there's plenty of dry powder to potentially distribute to shareholders.
Among the key factors driving stock market volatility are the rising interest rates the U.S. Federal Reserve is imposing in an effort to reduce the post-pandemic inflation rate. Interest rates are a proxy for the discount rate investors us to value future cash flows from corporations. The higher the interest rate, the higher the discount rate, and the lower the multiple stocks will command.
In this environment, so-called "low-duration stocks" – stocks of companies that distribute cash currently via dividends and buybacks – should offer something of a safer haven for investors. Discouraging buybacks leaves investors between a rock and a hard place. It would rob them of one of the few levers they have to navigate through elevated inflation and multiple/valuation-driven volatility on the other.
To use the kind of direct language Buffett might use – taxing stock buybacks is a policy mistake.