Don’t blame buybacks

Roughly one year after tax reform was enacted, the impacts are still being assessed. Both praise and criticism abound, mostly along party lines.

There are fair criticisms that can be made against the legislation; I have several of my own. But, on balance, the bill represents a net good for Americans and the US economy.

As a pillar of our nation’s fiscal regime, federal tax reform should be scrutinized and deliberated. My purpose in this post is to address one prevailing criticism of tax reform, because it is one I disagree with and is not a straightforward topic. My hope is that we can weed out erroneous criticisms like this one to make room for debate on legitimate contentions that could ultimately encourage improvements to tax policy in the long-term.

The controversy
The argument goes something like this: Corporate tax reform failed to realize its intended purpose of generating meaningful economic growth, because American companies reaped the lion’s share of benefits but did not subsequently distribute the incremental un-taxed earnings in the form of wage increases or investments in long-term growth projects that would benefit broader swaths of the economy. Instead, many corporations chose share buybacks – the insular practice of re-purchasing shares of their own stock, which accumulates wealth for privileged shareholders.

In other words, the criticism argues there are indeed monetary benefits from tax cuts, but they are concentrated in and retained by corporate management and wealthy investors.

The Atlantic recently published an article that eloquently captures this criticism. From my observations, this criticism is widely held among the legislation’s detractors, so I reference the article as a proxy for a more robust representation of this view.

My response
I disagree that an increase in the practice of corporate share buybacks in the wake of tax reform signals a failure in the law itself or in the broader thesis behind the idea of tax cuts. In general, the concerns described in the Atlantic article are exaggerated, and the narrative fails to capture both sides of the debate.

To be sure, the author is in fact onto something. The widening gap of income inequality is real, and getting to the root of the problem is paramount for policymakers. But she fails to adequately square corporate share re-purchasing with a fundamental failure in markets, much less a failure that’s linked to tax reduction. The argument demonstrates a deep misunderstanding of the complex flows of capital throughout our economy, namely, the cyclical nature of capital allocation decisions and how wealth generated in public markets is distributed across the economy.

So I take issue with this criticism for assigning blame incorrectly to tax cuts and have outlined five reasons in defense of the practice of share buybacks:

1. Back to basics

Philosophically, it has never been within the proper scope of our market-based economy to demand that the utility of any particular industry or individual actor within an industry be necessarily leveraged for the masses. Our expectations of corporate behavior should follow similar logic. 

We have to establish this from the outset to properly frame the conversation. The alternative is a top-down command economy, which is an entirely different debate.

Certainly the idea behind competitive markets is that, in aggregate and over time, market dynamics do in fact naturally align the interests of wider audiences in the economy by matching buyers and sellers, creating jobs, and increasing standards of living all driven by competition and  innovation.

2. Corporate Finance 101

At an academic level, the guiding purpose of corporations, the culprit of the criticism, is to maximize shareholder value. This makes sense, because owners of corporate shares are just that – owners of the company.

Maximizing value doesn’t mean corporations should immediately distribute all profits at every interval in which they are generated. Achieving this goal comes in all shapes and sizes. Timing is everything. As business conditions change, the methods corporations use to achieve this goal will vary.

Corporate strategies are rooted in fundamentals, which sometimes requires patience. If the argument is purely that tax cuts should result in immediate growth in order to be effective, then maybe the Atlantic article is right. But I would argue immediate capital investment was never the expectation (regardless of how the bill was messaged by the White House and Congress) and is not necessary to realize value from the law. 

Lower tax rates have already boosted project economics for many companies, giving some corporations the rates of return necessary to move forward with investments. In other cases, they’ve provided enough breathing room to remove burdensome debt off their books.

Other benefits take longer to surface. Healthy companies build strong balance sheets through disciplined budgeting rather than reckless spending. Capital spending and R&D budgets are most impactful when they are targeted, high-value investments. These take time to get right; not all investment opportunities are created equal. When done well, hiring ensues, and the innovation and enhancements to products and services ripples across the economy.

What about using it to boost employee compensation? This could be a plausible use of cash; after all, motivating and retaining workers is critical to any company’s success.

But boosting compensation through bonuses is probably the least helpful option. It provides zero long-term benefit and is subject to a higher tax rate. Using it for salary increases is risky, because it establishes a long-term precedent that revenue in subsequent years may not be able to sustain. This decision is unique to each individual company based on their financial health and their industry’s cycle.

3. Market cycles are just that – cycles. Not the “new normal”

The criticisms of share buybacks don’t take into account that markets are cyclical. Sure, buybacks may not be the optimal capital allocation for an economy over lengthy periods of time…but they won’t be.

Market dynamics are constantly changing. Growth conditions will return and necessitate capital investment, though the timing of this will be different across industries and strategies. Corporations will either respond accordingly or suffer the consequences of failing to keep pace with competitors that gear up to meet consumer demand.

The oil and gas industry is a prime example of a cyclical industry. You’re probably familiar with the more famous cycles, but here’s a more subtle one:

Since Q2, the markets have held public oil & gas companies (with exposure to US onshore unconventionals) accountable for how “disciplined” they are with their earnings. Investors are skeptical as to whether they can turn unconventional drilling opportunities (shale, “fracking,” et al) into profits, particularly in this volatile geopolitical environment. So they’ve favored companies who have re-purchased shares, resulting in a corresponding share price boost (to maximize shareholder value) while punishing those who deviate from this strategy via aggressive capital investment programs. Eventually, more investment into exploration and production will be needed to fill the coming gap between supply and demand. But for now investors are keen for companies to hone their expertise and processes before accelerating growth. The Wall Street Journal provides more color – here.

4. Buybacks are only a subset of the larger picture

Even if we assume this criticism is valid, the impact is exaggerated.

The scale of share buybacks is necessarily relegated to public companies listed on stock exchanges. While over 3,500 public companies exist today,  there are over 7 million private companies, far outpacing the number of companies able to re-purchase shares.

What’s more, according to a recent Harvard Business Review article, S&P 500 companies comprise less than 50 percent of business earnings and less than 20 percent of employment. This means, of course, that the balance of earnings and associated investment war chests comes from privately held companies. 

Don’t get me wrong, public corporations still play an outsized role in the economy. But putting it in perspective should temper the criticism against the practice of share buybacks.

5. It’s not just the wealthy who benefit

When a company re-purchases shares, it reduces the number of shares available in the market. In doing so, it concentrates the company’s value in fewer shares, which naturally boosts the overall value of each individual share. In this way, buybacks enhance the financial position of shareholders.

To be clear, the Atlantic article acknowledges as much. But it digresses to bemoan the demographics of these shareholders who benefit – that they overwhelmingly benefit the wealthy.

So who are these shareholders?

Well, according to a 2016 Gallup study, over 50 percent of Americans held stocks in 2016 (a low point since the survey began in 1998). This equates to more than 164 million people. For comparison, the top 1 percent would only be 3.2 million people. Moreover, roughly 35 percent of shares were held by middle class Americans, according to the study.

What’s more, a great deal of the shares are held by institutions that represent wide swaths of Americans, most notably those holding 401(k) plans and pension plans that serve as public retirement fiduciaries for our teachers, first responders, and civil servants. These won’t get counted in surveys, because they’re representation is aggregated at the institutional level under very corporate sounding company names. But they are most certainly beneficiaries in a big way.

We shouldn’t blame CEOs either. Less than 3% is owned by corporate management teams. Not only is this a minor share of the total, it’s a good thing for management teams to have skin in the game. Otherwise, there’s no incentive to deliver on performance and growth targets that shareholders demand.

The flip side is important too. It’s true that wealthy individuals and private equity firms do hold corporate shares and could benefit financially from corporate buybacks. But this is a positive, because the cycle doesn’t end there.

What are we assuming beneficiaries do with their boosted income? If they’re savvy investors, as the Atlantic article presumes, they’re likely reinvesting earnings into other companies, public and private, that need equity injections to fuel future growth and development that translates into job growth and innovation.