Why restricting and taxing stock buybacks is a bad idea
Stock buybacks are good for shareholders and governments should actively encourage them, writes UNSW Business School's Mark Humphery-Jenner
The United States recently passed the Inflation Reduction Act. The Act imposes a 1 per cent ‘tariff’ on stock buybacks. But, why? And, is a restriction on buybacks warranted?
What are stock buybacks?
Stock buybacks occur when the company has capital it wants to distribute to shareholders. One way to distribute the cash is via a dividend. The alternative is to use the cash to repurchase shares from shareholders.
Stock buybacks involve the company buying its own shares from existing shareholders. Oftentimes this is an ‘open market’ buyback. Here, the company buys shares from the market much like anyone else who wants to buy the shares. The only difference is that after the company has bought its shares, it retires the shares, thereby reducing the number of shares outstanding. The people who sell receive cash. The remaining shareholders then own a greater percentage of the company as there are fewer shares outstanding.
The question is then whether shareholders are ‘bad’ or ‘good’.
What are the stated reasons for restricting them?
Buybacks have been controversial. They have especially been made a scapegoat for alleged “under-investment” in vital industries, such as oil and gas. The claims are twofold: (1) Buybacks cause firms to ‘under invest’, and (2) CEOs might use buybacks to inflate the firm’s EPS so that they can hit a bonus target.
The claims against buybacks are not evidence-based. The UK commissioned a study by Professor Alex Edmans into stock buybacks. The study undertook an extensive literature survey in addition to its own empirical analysis.
The study found that there is no evidence that firms used buybacks to hit an EPS target they would not otherwise have hit. This implies that firms' CEOs are unlikely to be using buybacks to hit a bonus target. Furthermore, it is likely that most compensation contracts would be wise to the impact of increasing or decreasing the number of shares on EPS, and hurdles would adjust accordingly.
The study also indicated that firms undertake buybacks out of surplus cash. The study surveyed CEOs about their share buyback decisions. They found that CEOs buy back stock after they have made all relevant investments. And, they indicate that there is only a “very limited” scope for buybacks to crowd out investment. The literature also suggests a statistically insignificant relationship between buyback activity and CAPEX. Thus, there is little – if any – evidence to support the assertion that repurchases prevent firms from making value-creating investments.
The foregoing discussion suggests that the arguments against buybacks are not made out. That is, they are assertions that the evidence does not support.
Why are buybacks good for shareholders and the economy?
Buybacks are very likely beneficial for firms and the economy, rather than merely being non-negative.
Firms buy back stock from surplus cash. If they did not distribute the money, the firm would do one of two things, neither of which would create value:
• The firm could retain the cash on its balance sheet. However, companies are risky. And, shareholders demand a higher rate of return than the return earned on a cash account. Indeed, if shareholders wanted to invest in cash, they could choose to do so themselves.
• The firm could invest that surplus cash. However, by definition, surplus cash is cash left over after the firm has made all profitable investments. And, as indicated, there is no evidence that firms buy back stock instead of making profitable investments. Thus, the return on capital for any additional investment would be below the cost of capital. That is, the additional ‘investments’ would reduce shareholder wealth. Further, for the same level of risk, the shareholders could have achieved a higher return if they invested it elsewhere.
The evidence indicates that retaining excess cash holdings is associated with lower firm value. This is due to the aforementioned issues combined, potentially exacerbated by latent agency conflicts. That is, a self-interested or lazy manager might use that excess cash in a manner that benefits them, but not the firm. Thus, higher free cash flows, and cash holdings, are associated with worse acquirer returns. The negative relationship with firm value is especially so in poorly governed firms. This directly harms firms and shareholders. It also indirectly harms the economy by propagating inefficient and unproductive uses of cash. This ultimately reduces economic growth to below what it would be if the cash were deployed efficiently.
If the firm does buy back shares – or otherwise distribute cash – the shareholders can reinvest the cash themselves. In so doing, the shareholders can direct that money to a use that achieves a higher return on capital than do the excess investments. Compared with the firm retaining the cash, this would generate better returns for shareholders and is more economically efficient. Buybacks are therefore beneficial relative to encouraging firms to retain excess cash holdings.
Why then is a buyback tax or restriction is bad policy?
Given that buybacks benefit firms, shareholders, and economic efficiency, governments should encourage them. A buyback tax discourages buybacks by making them more costly. This is odd, as governments usually should try to incentivise – not disincentivise – good behaviour. Further, a buyback tax is normatively troubling: firms have already paid tax on their profits and a tax when distributing those profits, is clear double taxation.
A buyback tax (or restriction) might merely direct firms towards issuing dividends. However, these can be less efficient than buybacks. This is partly because of the signally implicit in dividends. Specifically, when a firm issues a dividend, the market often infers that future dividends will permanently increase. This makes dividends a relatively less efficient way to distribute cash than repurchases, which convey no such expectation. Dividends can also create issues associated with double taxation, especially with relation to overseas stockholders.
This all means that far from discouraging, restricting, or taxing buybacks, governments should encourage them. Legislation imposing such costs is bad economics and bad policy.
Mark Humphery-Jenner is an Associate Professor in the School of Banking & Finance at UNSW Business School. He has been published in leading management journals and his research interests include corporate finance, venture capital and law. For more information please contact A/Prof. Humphery-Jenner directly.