In the wake of the Republican smash-and-grab tax heist of 2017, many American corporations have had to decide what to do with their freshly repatriated profits and newly distended profit margins, so news junkies have been treated to an extended conversation about investment, payroll, and capital structure. This conversation has been complicated by the insistence of one particular party to the controversy on lying about what’s going on.
What can a company do with money?
I’m not speaking specifically of profits here. Lots of companies that don’t have any profits at all still have plenty of money: the money of their lenders and shareholders, for instance. Uber has money and no profits, Berkshire Hathaway has profits and money, and my sole proprietorship has profits but no money (since the profits are distributed to me every month, or whenever else I want).
But once a company has money, it has to decide what to do with it.
- A company can, of course, retain the cash, as many corporations did in their “foreign” subsidiaries for years while waiting for the opportunity to repatriate it cheaply.
- A company can spend the cash, for example on expanding operations, raising wages, giving employees bonuses, or buying new equipment.
- A company can pay out the money in dividends to shareholders.
- A company can pay down or retire its outstanding debt.
- Or a company can buy back its shares on the open market.
364 days a year financiers are perfectly honest about stock buybacks
Corporate profits in the United States are supposed to be taxed twice: once at the corporation level, and a second time when profits are distributed to shareholders. Long-term capital gains and qualified dividends are taxed at preferential levels for precisely this reason: corporate profits are taxed once at the corporation’s tax rate, then a second time at a rate depending on the shareholder’s taxable income (as low as 0%).
364 days out of the year, financial professionals are happy to tell you why they like stock buybacks: since stock buybacks are voluntary (it’s up to the shareholder whether or not to participate), the second step of taxation can be avoided, managed, or minimized.
A company can reduce its share count (increasing the proportional stake in the business of remaining shareholders, and their claim on future profits), without requiring the remaining shareholders to pay taxes on the increased value of their stake. In other words, share buybacks are a way for corporations to manage the individual income tax liability of their shareholders.
To be clear, dividends also allow shareholders to increase their stake in a company and their share of its future profits. If a company distributes a dividend to every shareholder and half the shareholders reinvest the dividend in the company and the other half do not, the half that reinvested the dividend have a higher proportional claim on the company’s future profits than the half that don’t, just as shareholders that don’t participate in a buyback have a higher proportional claim on future profits than shareholders that do.
This is what financiers mean when they say buybacks and dividends are “theoretically” identical. The difference is that all dividend recipients, those who choose to reinvest their dividend and those who don’t, are properly assessed income tax on the amount of their distribution.
On the 365th day, they tell the most preposterous lies
In the abstract of a forthcoming paper by Cliff Assmess of AQR Capital Management, titled “Buyback Derangement Syndrome,” he writes:
“The popular press is replete with commentary seeking to damn the behavior of corporate managers in handing free cash flow back into the hands of shareholders. These criticisms are often, even regularly, without merit (at least merit that can be demonstrated), sometimes glaringly so. Aggregate share repurchase activity has not been at historical highs when measured properly, and when netted against debt issuance is almost a non-event, does not mechanically create earnings (EPS) growth, does not stifle aggregate investment activity, and has not been the primary cause for recent stock market strength. These myths should be discarded.”
But this is nonsense. The problem with share buybacks is not that they “mechanically create earnings growth,” nor that they “stifle aggregate investment activity,” nor that they “cause…stock market strength.”
The problem with share buybacks is that they let corporations distribute profits to shareholders selectively, as Cliff would be happy to tell you the 364 days a year he’s not lying about why he likes them.
If you think buybacks and dividends are the same, let’s treat them the same
I don’t see any reason why share buybacks should be legal, but if the sages of our engorged and indulged finance industry think share buybacks are identical to dividend distributions, then let’s treat them identically. I have no objection to a company forcing all of its shareholders to sell back a certain percentage of their shares, thereby maintaining their proportional ownership of the company but reducing the number of outstanding shares — and resulting in the same tax liability on shareholders as a dividend distribution.
The pro-buyback propaganda sweeping the investment management space is just one recent example of a longstanding problem that has infected American discourse in a lot of different fields, and that the internet and social media have made more apparent in a lot of ways.
In earlier eras it may have been possible to deliver different messages to different audiences: “buybacks are a straightforward way to avoid capital gains taxes” to your investors and “buybacks are identical to dividends in every way and you’re an idiot for thinking otherwise” to any regulators who came snooping around your capital structure.
But today it’s a lot harder to get away with. If investment managers think the preferential tax treatment of stock buybacks is a good thing, they’re going to have to start defending it on the merits, if there are, indeed, any merits to defend.
Needless to say, I have my doubts.