Buyback Tax Will Distort Capital Markets, Hurting Smaller Innovative Companies

T he “Inflation Reduction Act,” newly signed into law by President Joe Biden, keeps the tax preference for carried interest yet creates a 1 percent buyback tax, thanks to a last-minute political deal by Senator Kyrsten Sinema. As buybacks are already taxed through capital gains taxes, it’s likely that firms will now move away from issuing buybacks, which are a quick and efficient way for large firms to return capital to shareholders who tend to reinvest such cash in smaller companies.

Fundamentally, a company can return cash to shareholders by issuing buybacks or dividends. In either case, each dollar is subject to two layers of taxation (corporate taxes and capital gains taxes in the case of buybacks, or corporate taxes and dividend taxes in the case of dividends). Buybacks and dividends can be viewed as almost interchangeable under today’s tax regime, which has been the case for almost 20 years.

In 2003, the dividend tax rate was cut to 15 percent, the same tax rate for long-term capital gains, to remove the tax advantage then afforded to buybacks over dividends. Firm dividend issuance was previously declining rapidly, but immediately after the 2003 tax change, firms began issuing dividends again. Since the 2003 change, tax rates on qualified dividends and long-term cap gains have been the same, so dividend issuance normalized.

In other words, a shareholder who sells back their stock is taxed on any resulting capital gain at the same rate that a dividend paid out would be taxed.

Now, let’s imagine adding a 1 percent buyback tax, as the “Inflation Reduction Act” does. A buyback that was previously subject to only two layers of taxation is suddenly subject to three layers of taxation (corporate taxes, capital gains taxes, and buyback taxes). Such “triple taxation” on buybacks could create a massive incentive for companies to issue cash to shareholders through dividends as an alternative to buybacks.

There is not much, if any, convincing empirical evidence that supports the claim that reducing buybacks would spur more capital expenditure or wage increases. Furthermore, Clifford Asness and his coauthors have shown that aggregate net buyback activity is not correlated with aggregate capital expenditures.

This seems like an intuitive result: When companies have no more efficient use for cash, they return money to investors, either through dividends or buybacks. Investors redeploy that cash by investing in other companies and projects that better use the cash for more productive means, which often happens to be innovative startups and small (but growing) companies that hire plenty of workers who are at or below the median income. In all, a buyback tax that slows this process ultimately hurts growing small companies who create better job prospects for the working poor with better uses of the redistributed cash.

The story of going after buybacks isn’t particularly new. Buybacks were largely illegal in the U.S. until 1982. Trapping cash inside firms through buyback taxes can promote excessive corporate perks, like too many corporate jets or overly lavish offices, something that was arguably evident with firms when buybacks were illegal.

Why do people seem to hate buybacks so much? Perhaps there’s an education problem. There exists a popular fallacy that seems to equate cash movements with wealth creation. Buying back stock is simply a cash movement, like returning cash to a bank depositor; the depositor and investor alike own that cash. Returning previously invested money by shareholders to shareholders is not the same as creating new value for shareholders, which perhaps is where some of the confusion lies among the public.

Some still seem to think that declaring dividends creates new intrinsic value. While it is true that when dividends are declared, statistically, stock prices tend to go up following the announcement, buybacks and dividends boost stock prices because they signal the likely future profitability of the company since only healthy companies can afford to redistribute cash, and doing so signals positive information about a company. Neither buybacks nor dividends creates new wealth intrinsically.

As the buyback tax becomes law, expect companies to move away from buybacks, and instead start issuing more dividends which has a lower tax rate, but remains a slower and more inefficient route to return cash to shareholders through regular recurring dividends on a quarterly basis (perhaps non-recurring special dividends will become more popular). Ultimately, this all just means those smaller, growing, and more innovative companies will likely have to wait longer to receive reinvested cash from the dividends of large companies which are being discouraged from issuing cash through buybacks.