Democrats’ Inane Stock-Buyback Tax

National Review Online

Thursday, August 11, 2022

 

As part of the cynically misnamed Inflation Reduction Act, Democrats propose to enact a new 1 percent tax on stock buybacks — the thing is, we already have a tax on stock buybacks, ranging from 15 percent to 37 percent. It’s called the “capital gains tax” or, for short-term gains, the “income tax,” and thanks to the presence of high inflation and the absence of indexation, it has become even more of a disincentive to investment than before.

 

The income tax — maybe you’ve heard of it?

 

Don’t let the financial jargon put you off — this isn’t all that complicated.

 

So, what’s a stock buyback, and why do companies undertake them? A stock buyback is, as the name suggests, what happens when a company finds itself sitting on a pile of extra cash and decides that the best use of that money is to give it back to investors — i.e., the people who own the company and who put up the money for its operations. Some of those investors are Wall Street types of the sort Democrats like to denounce when not shaking them down for donations, but many of them are (directly or indirectly) retired teachers and ordinary people of that sort — pension funds and retirement accounts are among the largest investors around. To be sure, gains that come into retirement accounts are tax-deferred, but when the money is eventually paid out to the retiree, the taxman will be waiting for his slice.

 

A company can return its profits to its investors in two ways: One is through dividends, meaning a payment of a certain amount of money per share to investors; dividends are paid out of profits that already have been subjected to the corporate-income tax, and investors pay another tax on the dividends once those checks hit their bank accounts. Dividends are usually taxed at the capital-gains tax rate of 15 percent or 20 percent but may in some cases be taxed at the ordinary income-tax rate of up to 37 percent. Return of the extra cash referred to above is often arranged via “extraordinary” dividends or by systematically paying ordinary dividends at a higher rate than might be justified by its earnings level.

 

The second and slightly more complicated way to return capital to investors is through a stock buyback. When a company buys back stock, those shares effectively cease to exist; with fewer shares on the market, earnings per share are higher; higher earnings per share tend to mean that the price of stock will go up, though buybacks by no means guarantee long-term increases in share prices. The idea is that share buybacks reward investors by making their shares more scarce and therefore more valuable, driving share prices up. It should be stressed, however, that this is by no means the only consideration that might drive a share up in the wake of a buyback. For instance, a company may well buy back shares as, again, a way of reducing excess cash, increasing (in theory, and to take one measure) its return on equity, something that may well be rewarded in the markets, which prefer to see capital deployed as efficiently as possible, as, indeed, should we all.

 

Investors who receive a benefit from selling their shares at a higher price pay a tax on that profit — that’s what a “capital gain” is. A married couple filing jointly typically pays a tax of 15 percent on the first half a million or so in nominal capital gains and 20 percent on gains beyond that, or else pays the regular income-tax rate on investments held for less than a year. The bigger the gain, the higher the tax. Because capital gains are only taxed once the profit is realized — once the appreciated asset is sold — there is no tax due as long as the asset is held, which may well be attractive to wealthy people and institutions who can let their investments ride for a long time before needing to cash out. But there is no avoiding the tax.

 

Democrats want to impose another tax on top of all that, charging companies a 1 percent tax on the value of shares acquired through a stock buyback. That doesn’t sound like very much, but it is, in fact, a relatively big bite: The current earnings yield for the S&P 500 is about 4.7 percent, and Goldman Sachs calculates that the new buyback tax could reduce earnings by as much as 0.5 percent per share. Put another way, that would mean about $10 billion a year in new taxes on investors, taxes that cannot be avoided even if those investors have placed their investment in a 401(k) or have offsetting capital losses — if, that is, the buyback tax doesn’t reduce buybacks, which, of course, it probably will.

 

There is a false impression, cultivated by Democratic class-warfare demagogues, that wealthy Americans and businesses somehow do not pay their “fair share” of taxes. In reality, high-income Americans pay practically all of the federal income tax (about 97 percent of it is paid by the top half of earners), while businesses and investors pay billions upon billions of dollars in taxes on business income, personal income, and investment income, not to mention the other taxes they pay on everything from commercial real estate to tariffs on imported industrial materials and manufacturing components. There is a good deal of special-interest favoritism in our tax code: For example, billionaire green-energy entrepreneurs and electric-vehicle makers enjoy very generous tax subsidies — subsidies that Democrats propose to sustain or increase in the very same bill that would impose higher taxes on businesses and investors that do not benefit from that kind of political favoritism.

 

One of the problems with our tax code is that it is so complex that the cost of complying with it represents a second substantial tax on its own — by some estimates, U.S. businesses spend more money on tax compliance than they actually pay in taxes. Making that already complex system more complex is good for no one — except for politicians who can hide behind the complexity of the tax code to hand out favors and sweetheart deals to allies and political supporters. Punishing investment is a particularly boneheaded way of going about raising revenue, even more so in today’s inflationary environment, a time when boosting the supply side is of even greater importance than normal — and we should probably point out that the $10 billion a year or so that this tax would raise in an optimistic scenario is chickenfeed in the context of the federal budget. If anything, we should be encouraging more Americans to save and invest in order to more fully avail themselves of the benefits of our magnificently productive economy and the innovative firms and entrepreneurs who make it so remarkably dynamic.

 

It is the case that investors expect a return on their investments and that any halfway sophisticated corporate management will structure its finances in such a way as to ensure that investors do not pay any unnecessary taxes — minimizing investors’ exposure to the capital-gains tax is, after all, one of the reasons that stock buybacks emerged in the first place as a favored strategy for big, cash-rich firms such as Apple and Alphabet, Google’s parent company, which has never paid a dividend as long as it has been in business. Investing for profit and engaging in intelligent tax planning is not a crime, and we should not be looking to punish it. One golden goose would be a miracle, but the U.S. economy has a remarkable flock of them.

 

This is one of many undesirable features of the so-called Inflation Reduction Act, which could very well turn out to be the Investment Reduction Act. We’d prefer to see a simpler tax code that produces more revenue than compliance costs, but, then, we’d also recommend against trying to fight inflation by detonating a new $370 billion money bomb in the middle of an already cash-flooded economy. Stupid policy ideas do not get less stupid when you bundle them all together in a single bill, but that is what Democrats apparently mean to do.