What would a better buy-back tax mean for the markets?

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The Biden administration has proposed, but not yet passed, a corporate share buyback tax as part of broader Build Back Better legislation. The buyouts drew bad political press for some time, although many are not sure the animosity is justified. If passed, what would a buy-back tax mean for the markets?

A story of redemptions

Buyouts have increased in absolute terms in recent years, although dividends have also risen sharply, as this data from Yardeni Research shows. There is some evidence that buybacks help stock prices, although their contribution to overall market growth appears to be minor. Along with dividends, buybacks have been part of the corporate finance toolbox for decades as a way to return money to investors.

Proposal

The Build Back Better executive stated the following on buyouts. “The framework also includes a 1% surtax on corporate share buybacks, which business leaders too often use to get rich rather than investing workers and growing their businesses.” Of course, discussions continue on what is included in the law and whether or not it will pass. There is therefore no guarantee that the proposal will pass in its current form, or not at all.

What are buybacks?

Share buybacks occur when an organization repurchases its own shares, so the total number of public shares in the company decreases.

As a result, the shares left after a buyback are often, but not always, worth more, since there are now fewer shares. This is not always the case, as the company has to spend money, which could be used for other purposes, to acquire the shares, so the value of the whole company will change as well. slightly.

In addition, the stocks themselves may not be traded for their fair value. For example, if a company’s stocks are overvalued or have many attractive, high-yielding investment opportunities, a buyback can be a bad decision in the long run and for the price of the stock. So whether buyouts are a good or bad decision for the company, its management, its employees and its shareholders depends on a multitude of factors. It is not in black and white.

More details on the buybacks are explored here by Clifford Asness and colleagues in an article published in the Journal of Finance. Interestingly, they find that, contrary to the Build Back Better claim, companies have typically often issued debt to finance buyouts, rather than divested business investments, and corporate investment has remained strong despite activity. redemption.

Nonetheless, they note that there are some potential benefits for managing share buybacks, such as potentially improving stock option payouts. However, these problems can be better overcome with better management contracts and better board oversight, rather than directly taxing buyouts.

What would happen if redemptions were taxed?

If redemptions are taxed, companies are likely to be tempted to spend more cash on dividends. If a company’s goal is ultimately to return money to shareholders, dividends are a similar way of doing it.

Dividends do not appear to be subject to additional taxation under Biden’s current proposal. We could therefore see a switch from redemptions to dividends.

However, dividends are generally viewed as a long-term commitment by management and investors. Companies often change their buyback policy on an annual basis, or sometimes more often, dividends are generally maintained and slowly increased over time. Redemptions are handled fairly loosely, dividends much less. There is no solid reason for this, but it is the conventions that guide the behavior of companies.

In addition, the 1% surcharge proposed on buybacks is low and the impact on business behavior may therefore be marginal.

Taxing redemptions at a low level is unlikely to have a dramatic impact on the market. Profits may decline slightly as more taxes are paid, in this case through a surtax on redemptions. Yet, since the tax in question is relatively low and can be avoided by using other means of returning cash to shareholders, such as dividends, the impact on the market may be small.


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