Rubio’s Misguided Buyback Tax
Senator Marco Rubio’s plan to tax stock buybacks in the hopes of spurring investment (based at least partially on a 1969 Yale Law Journal article) is heavily flawed for multiple reasons.
Respectfully, the senator seems to be operating under the incorrect belief that buybacks are tax-advantaged, when in fact buybacks are already taxed in the form of capital-gains taxes. Since 2003, when the dividend-tax rate was lowered to remove the tax advantage then afforded buybacks, the tax rates on qualified dividends and long-term capital gains have been the same.
In theory, buybacks are only tax-advantaged over dividends under today’s tax rules if companies want to distribute more cash to shareholders than the capital gain on a company’s stock. This is a very rare case as total cash returned to shareholders by a company is almost always less than the total capital gains investors experience. For instance, in recent history the average return for companies in the S&P 500 (11 percent annually over the past ten years) has far exceeded the average of such companies’ dividend yield (approximately 2 percent) plus their average net buyback yield (around 2 percent to 3 percent annually in recent years).
To illustrate buyback–dividend tax parity under today’s tax regime, let’s take a hypothetical example: Say an investor bought a stock at $100 and over the period of a year, the stock price appreciated by 10 percent to $110 after the company increased its profits and paid corporate taxes (at today’s 21 percent rate) on its earnings.
If the company pays a $2 dividend at the end of the year and the investor sells the stock at $108 (ex-dividend), the investor pays the 23.8 percent dividend tax on the $2 dividend received and 23.8 percent on the $8 capital gain. If the company buys back some of its stock at $110 instead of paying a dividend and the investor sells his shares at $110, the investor pays the long-term capital-gains tax of 23.8 percent on the $10 he made.
In either case, each dollar is subject to two layers of taxation (corporate taxes and capital gains or corporate taxes and dividend taxes). In both cases, the same overall amount of taxes is paid. Given the latter fact, buybacks and dividends can be viewed as almost interchangeable under today’s tax regime. The only difference is that investors decide when to sell their own shares in the case of buybacks.
Now, let’s imagine that Senator Rubio’s legislation is passed and a tax on buybacks goes into effect. The latter scenario thus changes. The company buys back some of its stock at $110, and investors pay a buyback tax (either directly or through the imputed value of the funds they would receive from hypothetically participating in the buyback even without selling) in addition to the 23.8 percent capital-gains tax. A transaction that was previously subject to two layers of taxation (corporate and capital-gains taxes) is suddenly subject to three layers of taxation (corporate taxes, capital-gains taxes, and buyback taxes), yielding a higher overall tax bill.
Such “triple taxation” on buybacks could cause a massive incentive for companies to issue cash to shareholders through dividends as an alternative to buybacks. Nor is there any reason to believe that reducing buybacks would somehow spur capital investment. As Cliff Asness and his co-authors have shown in a recent academic paper, aggregate buyback activity is not correlated with aggregate capital expenditures (fixed investments in property and equipment).
When companies return money to investors, whether through dividends or buybacks, investors redeploy that capital by investing in other companies and projects that can use it for more productive means. There exists a popular fallacy among populists and socialists alike that seems to equate cash movements with wealth creation. Returning previously invested money to shareholders is not the same as making new money for shareholders (generating returns). Both buybacks and dividends are often received positively by the markets, resulting in a bump in a company’s stock price, because they signal the likely future profitability of the company, but neither creates new wealth for the company or investors on its own.
Dividends and buybacks are purely cash movements. They are, in essence, taxed equally, something which I’d respectfully submit Senator Rubio should consider along with the fact that capital expenditures have significantly increased since the Tax Cuts and Jobs Act (TCJA) was signed into law in 2017. There are plenty of policy changes our economy could use, including Senator Rubio’s excellent idea to make permanent the capital-expenditure full-expensing measures in the TCJA and many measures in his recently outlined plan to encourage innovation. A buyback tax is not one of them.
