While we are now well aware of the unpatriotic-ness of tax inversions, Goldman Sachs raises the red flag on another corporate action that is about to become highly politicized - share buybacks. The last (and only) pillar of buying left in the US equity markets is set to draw political attention and likely to gain prominence, particularly ahead of the 2016 election.
As Goldman Sachs' Jan Hatzius explains,
- Stock buybacks are likely to grow strongly again this year and the trend has begun to draw political attention. We don't expect any buyback-related rules to change in the near term, particularly in light of Republican majorities in Congress, but the subject looks likely to gain prominence, particularly ahead of the 2016 election. However, even if changes were made to discourage buybacks, it is not clear whether business investment or hiring would increase, as proponents of a change suggest.
Stock repurchases continue to grow and have begun to attract political scrutiny. Buybacks have increased throughout the recovery, totaling over $500 billion in 2014 among S&P 500 companies and representing more than one-third of cash use and about half of earnings. Our equity strategists expect buybacks to rise to around $600 billion in 2015.
Some lawmakers have linked share repurchases with stagnant wages and a lack of business investment and have recently begun to call for regulatory changes to constrain repurchase activity. The two most obvious avenues for policy change would be securities rules related to the transactions themselves, or tax changes that increase the relative cost to corporations of buying back their own stock instead of paying dividends or making investments in productive capital.
Most of the political focus to date has been on securities rules. Sen. Tammy Baldwin (D-WI) sent a request for information to the Securities and Exchange Commission (SEC) in late April. Her letter requested SEC analysis on the long-term impact of the original 1982 rule providing a legal “safe harbor” for the repurchase of shares by the issuer, an accounting of investigations into violations of the buyback rules, and an assessment of the rule’s effect on capital formation. Sen. Elizabeth Warren (D-MA) has also recently raised the issue, describing buybacks as “stock manipulation” and calling on the SEC to consider changing the rules.
Corporate income tax considerations have played a smaller role in the debate thus far. Currently, buybacks themselves are not deductible but two somewhat related practices are.
- First, some buybacks are funded by debt issuance, the interest on which is tax deductible.
- Second, the increased importance of compensation through stock options may have contributed to the increase in share repurchase activity, as firms repurchase stock to offset the issuance of options-related shares. Stock option related costs are often deducted from taxable income as a compensation expense.
To our knowledge, there has been no proposal to change tax treatment of debt-financed repurchases, but Sen. Jack Reed (D-RI) has offered legislation to repeal the tax deductibility of performance based pay (e.g., stock options) in excess of $1 million per year. (Congress repealed the deduction for cash compensation greater than $1 million in 1993.) While not directly related to share repurchases, policy changes that reduce the use of stock options might also reduce the prevalence of stock buybacks.
It is unlikely in our view that such efforts will get very far this year or next. Tax-related changes would seem to face the highest hurdle, since any significant tax change would require legislation, which seems unlikely to pass in a Republican-controlled Congress. As a procedural matter, the SEC has the ability to change some of the rules related to buyback transactions--for example, it could make changes to the rules it originally issued in 1982 that provides a "safe harbor" from legal liability for repurchases that meet certain restrictions related to manner, timing, price, and volume of purchases. However, it is not clear that the SEC would make such a change; Democratic Commissioner Stein has spoken about share repurchase policy, but the topic does not appear to be a concern for the commission more generally.
That said, the political focus on the issue seems likely to increase further, for three reasons.
- First, as noted above, buybacks continue to grow. This has raised concerns not just among progressive lawmakers but also among some investors and analysts who suggest that the funds might be better put to other uses.
- Second, the White House is expected to nominate two SEC commissioners, one Republican and one Democrat, to replace two departing members. It seems likely that the nominees will be pressed on this issue among many others.
- Third, as the 2016 presidential election campaign gets into full swing later this year, candidates will come under pressure to take positions on a number of financial regulatory issues, and this may be among them.
In the seemingly unlikely event that restrictions on buybacks were put in place, it is unclear what effect they would have on business investment. Technical changes to share repurchase programs might not have much of an effect, as long as companies are still free to repurchase shares in some manner. Moreover, since firms can currently borrow at low rates, there may be less of a tradeoff between making profitable capital investments and returning capital to shareholders than usual.
That said, in a normal interest rate environment, companies must choose how to allocate limited funds, and the return of capital to shareholders might constrain business investment in some cases. To investigate this, we add S&P 500 aggregate buybacks and dividends to a model of capital investment that forecasts growth in real capital spending using output growth, corporate profits, access to credit, and the capital stock. Adding various lags of aggregate S&P 500 buybacks does not improve the model's fit, but including a variable representing total return of capital to shareholders, i.e., buybacks plus dividends, explains an additional 10% of the variation in capital investment from 1990 to 2014. However, the relationship between capital return and investment in any given period is fairly loose; each percentage point increase in capital returned to shareholders is associated with 0.04pp slower capital investment growth, suggesting that the 13% increase in buybacks and dividends that our equity strategists forecast would be associated with capital investment growth roughly 0.5pp slower than if no payouts were made, or about 0.1pp slower than if companies grew combined dividends and buybacks by 10% as they did in 2014.
Overall, corporate share repurchases look likely to draw increased political attention, but rules changes are unlikely in the near term. To the extent that any policy changes are made, the effect on business investment is unclear but seems likely to be small.