WASHINGTON — President Trump has sharply criticized major corporations for using the proceeds of the 2018 tax cut to repurchase outstanding shares of stock of their company. Trump said that corporations were not supposed to use this extra cash flow to initiate stock buybacks. They were expected to increase investments, thereby expanding the economy. But Trump is wrong on this one. Stock buybacks are actually good for the economy.
Stock buybacks have been going on for years
Corporations have been buying back shares of their common stock for years. In fact, from 2007 to 2017, before the GOP tax cut, S&P 500 companies purchased $4 trillion of their outstanding shares. They also paid shareholders more than $3 trillion in dividends.
Many well respected economists like Nobel Prize winner Paul Krugman claim that because of stock buybacks, the tax cut did not lead to an investment boom. He said, “looks like the tax cut is a nothing burger.”
Essentially following this argument is exactly why Trump is wrong. But so is Krugman. Investments have increased. But, enabled by stock buybacks, they unfold in different and perhaps less visible ways.
Business investment did not increase after corporate tax cut. But…
It is true that total business investment did not substantially increase in 2018 or 2019. But this did not happen because of stock buybacks. It was mostly due to corporate uncertainty, both on the domestic side and in foreign trade. It was also due to the Federal Reserve’s reversal of their quantitative easing (QE) policy.
In 2018, lowering the corporate tax rate from an average of 35% to a flat 21% did increase corporate cash flow. Trump hoped that corporations would use those funds to increase business investment, which, in turn, expands the economy. Unfortunately at the same time, interest rates rose substantially since the Fed raised rates a total of eight times from the end of 2016 to the end of 2018. The Fed also reversed quantitative easing and reduced the money supply as well. This tended to reduce overall US economic growth. Directly and indirectly, the Fed’s actions provided fewer investment opportunities.
Internationally, the US became involved in trade wars with Mexico, Canada, South Korea, Japan, India and China. Because of this additional uncertainty, businesses were reluctant to invest.
The owners of the corporations, stockholders, voiced the opinion that since the corporation has few profitable investment opportunities, corporations should give the extra cash flow to them. Some stockholders claimed they could find better and more profitable investment opportunities outside corporate America, also concluding that corporations should give them the extra funds to invest. Still other stockholders agreed that corporations should give them the funds, but they did not want dividends. Their reason? Being paid the extra cash via dividends would incur additional tax liabilities for those investors.
What did corporations do with the proceeds from the tax cut?
Many corporations simply decided to invest the money by buying back their own shares. In a positive economic climate, share buybacks like these have the effect of lowering a corporation’s price earnings ratio (PE) and increasing its earnings per share (because there are less shares avilable to the public.)
By reducing the number of shares outstanding, the price per share would increase due to the more attractive earnings per share. Selling their now more valuable shares for a handsome profit enabled current shareholders wishing to fund their own ventures with the cash to do so.
Stockholders not choosing to their shares, would benefit as well by the increase in the stock price. But by holding those shares rather than selling them, they could ride the company’s profitability without incurring tax liability on their accruing capital gains. In other words, instead of receiving a $1 dividend, which is taxable at the current capital gains rate, the buyback program could result in the share price increasing by $1, which would not be immediatly taxable. Whether buyers or holders, veryone wins.
Stated another way, the net result of stock buybacks is that the selling shareholders taking the profits now have fresh capital to invest. And they invest them to grow more profitable ventures requiring capital to expand. Since this new capital flows to companies most in need, it becomes an overall positive for the economy.
Further, the higher stock price generated in part by buybacks, meant corporations could raise equity capital more easily. And with less diluting of ownership. This also encourages more growth.
The purpose of the 2018 GOP tax cut
The purpose of the 2018 GOP tax cut, which reduced tax rates for all Americans — including the highest income earners and corporations — was to create more capital. Since the US economy is capital intensive rather than labor-intensive, the new capital would eventually be invested in companies that see and execute highly profitable opportunities. Highly profitable companies are those that generate a large market demand for their goods or services for which little or no supplies currently exist.
By investing in these companies, economic growth tends to follow, though admittedly a time lag always exists in this process.
Currently, once the ongoing Coronavirus problem is resolved, the economy once again will be poised for rapid long-term growth. The creation of new capital is vital to support this growth. Companies may invest directly in their current businesses. Or they may return the new capital to some of their shareholders to invest in other businesses. In both cases, growth naturally follows. Companies and investors alike will invest the new capital.
Why Trump is wrong on this issue
Creating new capital also means companies will find it easier to move production out of China and back to the US. Chinese manufacturing became highly attractive due to low wage rates and the high productivity of Chinese workers. The manufacturing brought back to the US will be capital intensive, meaning the use of robots, automation and artificial intelligence. Which require fresh capital to fund, some of which stock buybacks ultimately generate.
That’s why President Trump is wrong on this one. The GOP tax cut created new capital. Let the market decide where that capital is best employed. Stock buybacks are simply part of this process.
— Headline image: Mr. Moneybags loves stock buybacks. So should we.
(Vintage cartoon by Thomas Nast, public domain image.)