In a desperate effort to make the Cut Inflation Act numbers work, Senate negotiators imposed a last-minute tax on corporate stock buybacks of 1%. Although the $74 billion expected to be generated by this tax represents just over 0.1% of projected revenue over the next decade, it may be one of the most important provisions of the new law.
This provision is important for two main reasons. The first is simple: while buyouts are often demonized for silly reasons, their current tax treatment is a very real problem. Share buybacks and dividend payments are alternative mechanisms through which companies pay out profits to shareholders. Dividend distributions are taxed directly at the individual level. However, the money companies pay out in buyouts, which comes back to shareholders in the form of a rise in share price, is not subject to tax.
There is no logic to this asymmetry. The government has no reason to prefer companies to pay out money in the form of share buybacks rather than dividends, but the tax treatment clearly encourages them to do so. As a result, the share of after-tax profits paid out as dividends has fallen to less than 43% over the past decade, from more than 56% in the 1960s, before the legality of buyouts was established.
The wealthiest people are also likely to be the main beneficiaries of this asymmetry. Taxes are only due when stocks are sold at a gain, and many of the wealthiest people will have little need to sell stocks. They can defer tax indefinitely and even pass shares on to heirs, without anyone paying capital gains tax.
Most middle-income shareholders have most of their shares in retirement accounts. For these people, the tax treatment of dividends and redemptions ends up being identical. All returns from a 401(k) account are taxed as normal income when the money is withdrawn.
In addition to the reduction of this asymmetry, the tax on redemptions has the advantage of taxing the holdings of shares which escape the tax. This would include the equity holdings of foreign investors, who own almost 40% of the market. To be clear, a 1% tax on redemptions is a relatively small step in this regard, but it goes in the right direction.
While reducing the asymmetry between the tax treatment of dividends and redemptions is a big deal, it’s the least important reason to celebrate this provision of the new law. Taxing share buybacks is a step towards moving from a corporate income tax base, which is far from transparent, to a taxation of shareholder income, which is 100% transparent.
The point here is simple. The IRS has no direct way of knowing how much profit a company has made. It relies on business accountants to apply rules on depreciation, expenses, and many other factors that allow them to determine how much of a business’s revenue is profit.
Needless to say, corporate accountants have a huge incentive to understate profits reported to the IRS. They employ a wide variety of tactics, some legal and some dubious, to make their US taxable profits look as low as possible.
In some cases, they can be extremely innovative in showing US profits as profits made in tax havens like Ireland or the Cayman Islands. They have also developed some very creative mechanisms to defer profits to times when it might be more convenient to recognize them. And sometimes they cheat.
Basing corporate income tax on shareholder returns (capital gains and dividends) removes this problem altogether. These are numbers that are immediately available on any financial website. It is simply the increase in market capitalization during the tax year, plus dividend payouts.
The IRS could quickly calculate the tax liability for every publicly traded company in the country on a single spreadsheet. It may be desirable to allow for multi-year averaging to smooth tax liability and to have a rule for allocating tax liability among national jurisdictions. But these issues pale in comparison to the problems the IRS faces when reviewing profit calculations.
We can always debate what tax rate we want to impose – the point is, we can count on actually collecting the tax rate set by Congress. While the nominal tax rate is 21%, in 2019 corporations only paid 12.2% of their profits in tax.
More important than targeted revenue collection, moving to a corporate income tax based on shareholder returns will largely eliminate the tax shelter industry. All the accountants and tax lawyers who earn big salaries by finding creative ways to reduce corporate tax liability will instead have to find productive work to support themselves. The IRS could also drastically reduce the size of its staff dedicated to auditing corporate tax returns.
A 1% tax on share buybacks is, of course, far from changing the corporate tax base from profits to shareholder returns. However, it is a huge first step. After this measure has been in place for two or three years, it will be possible to compare the targeted revenues with what the government collects. We will also have good data on the cost of the application, which will probably be insignificant since the money spent on redemptions is completely transparent.
This should create support to go further. It makes more sense to tax the returns to shareholders that we can see than to tax the corporate profits that corporate accountants calculate for us. Getting your foot in the door with this tax on buyouts should help make this point clear to everyone.
This first appeared in Bloomberg.