by Mikael Shameti
Very simply put, stock buybacks are when a company buys shares of itself. Some people directly have their share purchased so they get money for giving up their shares to the company.
Stock buybacks have been a contentious topic for multiple years. In the CARES act passed in April, it reared its head as Democrats forced Republicans into including a provision to ban stock buybacks for one year to any company that received money from the government (Reed, 2020). And it isn’t only Democrats that have a problem with stock buybacks. Complaints have come from Republicans as well, like Republican Senator Marco Rubio last year who wanted to tax it more aggressively (Scott and Stewart). Democrats mostly see stock buybacks as a way that the rich get richer while average people get nothing. More moderate Republicans like Marco Rubio see it as more of a tax loophole problem where companies found a way to minimize taxes. The problem with all these complaints is that stock buybacks aren’t a problem. Despite concerns from people like Senator Bernie Sanders and Senator Chuck Schumer that stock buybacks should instead be used to reinvest in workers, the problem with them is how they are taxed compared to dividends, but that isn’t a problem with stock buybacks. It is a problem with the tax code. Furthermore, the desires of people like Chuck Schumer and Bernie Sanders for companies to reinvest in workers are more reachable with direct legislation.
Very simply put, stock buybacks are when a company buys shares of itself. Some people directly have their share purchased so they get money for giving up their shares to the company. The rest of the shareholders generally see a rise in the price of the stock because when a company buys back shares, investors see that the company is doing well. This is because many tools that investors use have the number of shares as a part of that tool. One popular tool to use is earnings per share or EPS. This is calculated with net income minus preferred dividends all divided by the shares outstanding. This essentially tells you how much earnings a company makes per share you own. From the formula, you can tell that decreasing the shares outstanding will increase the EPS. This increase in EPS makes investors value the company more so the stock price goes up. Because stock buybacks decrease the number of shares outstanding, the stock price generally goes up. So in the end, stock buybacks are a way for companies to use cash to return value to investors. This is practically identical to dividends except for one thing, taxes.
The most popular argument against share buybacks is that companies are using all their money on buybacks instead of reinvesting in the company.
The difference between dividends, where a company directly gives cash to investors, and share buybacks is taxes. Say I own 1000 shares of a company for $10 a share that issues a dividend of 1 dollar per share. When the dividend arrives, I get $1000. This is taxed as if you just earned $1000 from a normal job or with a capital gains rate of 0%, 15%, or 20% if the dividends qualify for specific criteria to make it a qualified dividend (IRS, 2020, p. 19). The important thing to remember is that they are taxed at the moment when when you get the money. However, let’s say there is a share buyback that results in a share price of $11 per share. I went from $10,000 to $11,000 in assets in both examples, but in the second one I won’t get taxed on the increase in stock price until I sell the stock, which for someone my age could be decades from now. And when it is sold, it is taxed at the capital gains rate described above.
Despite share buybacks being just another way of returning capital to investors, they get an unfair reputation compared to dividends. If you replace “share buybacks” with “dividends” in any argument against share buybacks you can quickly see the problem with most of the arguments. The most popular argument against share buybacks is that companies are using all their money on buybacks instead of reinvesting in the company. The problem with this is that most companies want to reinvest. If companies found good opportunities to invest they would take them. We could have them increase wages or provide healthcare as Sanders and Schumer argued in their 2019 New York Times article, but that is just reinvesting into your workers, something the company would already do if it was worth it. Companies only reinvest in their workers if they need to do it to attract workers or retain old ones. We can’t expect companies to give to their workers out of the kindness of their hearts because that’s not what companies are for. So if companies can’t find opportunities to invest and they can’t do share buybacks, then all they can do is sit on their money, which is even worse for society, or issue dividends, which doesn’t solve the original goal of getting companies to reinvest.
The money in investors' hands generally doesn’t just sit in their bank account, they do what their name says with the money, invest.
A follow-up to this might be that companies sitting on cash aren’t necessarily a bad thing. People in favor of this argument might argue that if companies saved more money, they would be able to survive things like the current pandemic without government bailouts. This sounds appealing but if every company did this then that means money that would otherwise be back in investors’ hands would sit in a company’s bank account. The money in investors' hands generally doesn’t just sit in their bank account: they do what their name says with the money, invest. Investors would invest in companies like Apple, Amazon, Google, etc. which make revolutionary products that change the way our world works. If you make it impossible for companies to return value to investors, then potential "Amazons" and "Googles" in their infancy might never get off the ground.
Considering all of this, it is good that Sanders and Schumer’s New York Times article doesn’t call for an outright ban on stock buybacks as some people have. However, they still want stock buybacks to be restricted until you meet certain requirements like a higher minimum wage, providing healthcare, paid time off, etc. They correctly point out that this might lead companies to simply start using dividends instead, but they vaguely hand wave away concerns by saying that additional tax policies about dividends should be considered. If we give them the benefit of the doubt and assume they figure out the kinks of their plan so companies don’t exclusively use dividends, then we just end up with a scenario where you essentially mandate a higher minimum wage, better healthcare, paid time off, etc. for all but small startup companies that won’t issue dividends or buyback stock until they grow. If that is the result, then Sanders and Schumer should just pass a law mandating that large companies have a higher minimum wage, better healthcare, etc. instead of changing the way dividends and stock buybacks work.
You can delay paying taxes on share buybacks for years compared to dividends meaning that, in general, share buybacks are preferred to dividends.
Because attacking share buybacks with the same arguments that can be used against dividends quickly leads to bad outcomes, it makes sense that the best argument against stock buybacks attacks where it is different from dividends. This is the tax difference that was highlighted earlier. You can delay paying taxes on share buybacks for years compared to dividends meaning that, in general, share buybacks are preferred to dividends. The counterargument to this is to simply tax share buybacks in the same way you tax dividends so they are identical for tax purposes as well. An example of a proposal to tax stock buybacks is from Republican Senator Marco Rubio (Scott and Stewart, 2019). The issue is with the tax code, not with stock buybacks itself.
If there are no problems with something, then it shouldn’t be banned. Nearly all arguments against stock buybacks can also be used against dividends, but that quickly leads to an absurd world that doesn’t solve any of the problems that are usually blamed on stock buybacks or even creates new ones. Proponents of restricting stock buybacks in one way or another either don’t know of the similarities to dividends or ignore them. Additionally, their goals of improved worker living standards can more easily be achieved by passing legislation that directly improves it. Finally, the one good argument against stock buybacks can be solved by fixing the tax code, which has nothing to do with stock buybacks itself. So, stock buybacks should remain one tool of many for corporations to use as they see fit.
References
Reed, E. (2020, May 12). Stock Buyback Bans in the CARES Act. Retrieved from https://smartasset.com/financial-advisor/stock-buyback-ban
Schumer, C., & Sanders, B. (2019, February 4). Schumer and Sanders: Limit Corporate Stock Buybacks. The New York Times.
Scott, D., & Stewart, E. (2019, February 20). Marco Rubio's plan to fix the GOP tax cuts starts with stock buybacks. Retrieved from https://www.vox.com/policy-and-politics/2019/2/20/18225086/marco-rubio-stock-buybacks-tax-plan
U.S. Department of the Treasury. Internal Revenue Service. (2020). Publication 550: Investment Income and Expenses (Cat. No. 15093R). Retrieved from https://www.irs.gov/pub/irs-pdf/p550.pdf