Democrats Seek to Eliminate the Stock Buyback Advantage

A provision in the emerging Build Back Better framework would remove tax advantages for corporations that transfer profits to their shareholders through stock buybacks rather than dividends.

Corporations can shift their profits to shareholders either by paying them stock dividends or by buying their own stocks, which increases the value of the stocks held by shareholders. Shareholders pay income tax on stock dividends, though often at lower rates than wages and salary income. Stock buybacks, on the other hand, result in capital gains (because they increase the value of the stocks) that may not be taxed for years and in many cases are never taxed at all.

An important reform in the bill before Congress would tax stock buybacks in a way that is more comparable to how dividends are taxed. Corporations would be required to pay a tax equal to 1 percent of their stock repurchases, ensuring that profits shifted to shareholders in this way are subject to some federal tax.

How Stock Buybacks Are Taxed Under Current Law

There are three distinct tax advantages for corporations that remit cash surpluses to their shareholders as stock buybacks rather than dividends.

First, whereas dividends are taxed the year they are distributed, under current law, shareholders do not owe taxes on capital gains resulting from stock buybacks until they realize those gains, meaning they sell the shares and receive some profit. If the owner of the stock holds onto those shares, they can avoid paying taxes on the gains for years or decades. Meanwhile, if the asset continues to appreciate, the owner has increased their purchasing power—something that most economists would identify as income whether the gains are “realized” or not.

Second, if the shareholder never sells their stocks, their heirs will benefit from the stepped-up basis rule. Under current tax law, when the owner of an asset dies, the basis value of that asset is “stepped up” to the value at their death. Their heirs then take over those assets with a blank slate when it comes to capital gains. This means that much of the appreciation of corporate stocks resulting from buybacks is never taxed.

Third, while the tax rates are the same for qualified dividends and capital gains for domestic shareholders, this is not always the case for foreign investors. The top rate on dividends paid to foreign shareholders is 30 percent (although in most cases this is reduced to 15 percent through a tax treaty). On the other hand, foreign investors are not subject to the U.S. federal personal income tax that would apply to capital gains on shares when they sell them. Depending on the income taxes they pay in their home countries, they could pay much, much less on capital gains that result from stock buybacks than U.S. shareholders would pay, and they will pay nothing to the U.S.

The first and second tax advantages go mainly to wealthy, white Americans. As with most types of capital assets, stock holdings are highly concentrated among the wealthiest families. The wealthiest 10 percent of American families held a median $781,500 in stocks in 2019, compared to just $2,350 for the bottom 25 percent. Similarly, stock holdings are highly divided by race and ethnicity. 61 percent of white families owned stocks in 2019 compared to just 34 percent of Black families and 24 percent of Hispanic families.

The third tax advantage goes entirely to foreign shareholders. Steve Rosenthal and Theo Burke of the Urban-Brookings Tax Policy Center have estimated that foreign shareholders own about 30 percent of U.S. publicly traded stock, and therefore receive 30 percent of the appreciation of these stocks. The preferential treatment of stock buybacks over dividend distributions puts billions of dollars of potential government revenue for domestic necessities like health care and education into the pockets of wealthy overseas investors.

Why Stock Buybacks Are Becoming More Important

When a company has cash holdings, it can either invest those holdings in expanding its operations, hiring new employees, building new plants, and buying more equipment, or it can hold onto that cash (likely through investments in other corporate stocks and bonds) to increase its market capitalization for later investments. Alternatively, if the company decides that there are no desirable investments and that there is no advantage to further increasing its capital, the company can distribute some of this cash to its shareholders.

Historically, companies would do this through dividend distributions. More recently, companies have increasingly used stock buybacks, which were generally illegal until the 1980s. By repurchasing shares of its own stock off the market, a company can remit a portion of its cash savings to shareholders.

For example, if a publicly traded corporation earns $100 million in profit in a given year and has 10 million outstanding shares, the earnings per share (EPS) are $10. If the company repurchases 10 percent of its shares, 9 million shares would remain outstanding, resulting in an EPS of $11.11, an 11 percent increase in EPS for its remaining shareholders. On the other hand, the company will have less capital going forward. This can lead to a drop in the company’s value if investors feel that it is missing future investment opportunities. In practice, studies have shown that companies typically engage in buybacks when they have excess capital relative to their long-term investment opportunities.

When companies use portions of their cash reserves to purchase their own stock, they are telling the market that their stock is undervalued. Beyond share price, this can improve other financial metrics that traders use to make investment decisions, including a company’s price-earnings ratio (P/E), return on assets (ROA), and return on equity (ROE), though the relationship is not mechanical. For most of the 20th century, this was regarded as a form of market manipulation, and stock buybacks were generally illegal until 1982. After the SEC created a safe harbor for stock buybacks, their use grew exponentially, resulting in corporations (legally) manipulating their own market metrics to make themselves more valuable to investors.

This is particularly important in the wake of the Tax Cuts and Jobs Act of 2017. When Congressional Republicans passed that law, they claimed that the tax cuts would pay for themselves by spurring a wave of investment, creating new jobs, and raising wages. This did not happen. Instead of using the tax windfalls to invest in the domestic economy, big businesses largely shifted the savings to their shareholders by buying their own stocks.

Stock buybacks did not begin with the TCJA, but many companies did find them to be a more lucrative use of their tax savings than investing in new plants or employees. In 2018, the first year that the TCJA was in effect, U.S. companies spent $1 trillion on their own stock. As early as December of that year, just 12 months after the tax cuts were signed into law, one prominent Republican senator was already acknowledging that companies were using the TCJA’s corporate giveaways to enrich shareholders through stock buybacks, not to invest in domestic factories and jobs.

A corporate tax-rate cut makes all corporate assets more valuable, causing a bigger return to investment no matter how it is used. In our globalized and financialized economy, though, it’s as likely to induce stock buybacks as it is to spur the construction of new American factories.

Sen. Marco Rubio

Lawmakers now have an opportunity to right the ship on corporate stock buybacks through the President’s Build Back Better plan. While Sen. Rubio’s 2018 plan would have treated stock buybacks the same as corporate dividends, an alternative proposal from Sens. Ron Wyden and Sherrod Brown would directly tax the corporations who carry out these buybacks.

Proposals to Reform the Taxation of Stock Buybacks

Sen. Rubio’s 2018 proposal would have taxed corporate shareholders benefiting from stock buybacks as if they received a dividend. Since most dividends from U.S. companies are already taxed at the preferential capital gains rate, the primary change under this proposal for U.S. shareholders would be the timing. Shareholders would owe taxes on their income resulting from stock buybacks when the buybacks occur rather than when they sell their shares. Additionally, shareholders and their heirs would not be able to avoid taxes altogether through the stepped-up basis rule. For foreign investors, the change would be much more dramatic. Rather than paying a zero U.S. tax rate on the capital gains resulting from the stock buyback, they would owe taxes at their dividend rate (up to a top rate of 30 percent, depending on their home country).

More recently, Democrats on the Senate Finance Committee including Chairman Ron Wyden and Sen. Sherrod Brown have proposed an alternative strategy of taxing corporate stock buybacks. This plan, included in President Biden’s Build Back Better framework, would levy an excise tax on the purchase of stock buybacks. The excise tax rate would have been set at 2 percent under the Wyden-Brown proposal but was dropped to 1 percent in the Build Back Better bill. Compared to Sen. Rubio’s proposal, the Wyden-Brown proposal would indirectly address the advantage of distributing cash to shareholders via buybacks rather than dividends. It would not limit the ability of U.S. shareholders to defer taxes on their capital gains until they are realized, nor would it require foreign investors to pay any capital gains taxes. Instead, it would affect the value of their shares by reducing the total assets of the company by the amount of the excise tax.

It is unlikely that a 1 percent or 2 percent excise tax rate would be high enough to erase the tax advantage of stock buybacks over dividends for taxable shareholders, particularly foreign shareholders. To raise the same amount of revenue as the dividend tax, the excise tax would need to be equivalent to the average tax collected on dividends. The Tax Policy Center has estimated that foreign investors own about 40 percent of U.S. corporate stock (including both publicly-traded and privately held stock), and domestic taxable accounts own about 25 percent. The remaining stocks are held in non-taxable accounts. Assuming an average dividend tax rate of 15 percent for foreign investors and 23.8 percent for U.S. investors, the average tax collected on dividends would be 12 percent, much higher than the rates proposed by Democratic leaders.

On the other hand, an excise tax on stock buybacks would make dividends clearly preferable for non-taxable accounts like retirement accounts and non-profits that are exempt from the dividend tax. The owners of these accounts would prefer a tax-free cash distribution over a stock buyback that triggers even a modest excise tax for the corporation.

The Wyden-Brown proposal would be an improvement over the current system that allows foreign shareholders to pay a zero-tax rate and wealthy U.S. shareholders to defer on their taxes potentially forever. It would also be simpler to implement and administer than the Rubio proposal, one plausible reason why Democrats are pursuing this method.

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