Stock Buyback Tax: Tightening Loopholes for the Wealthy Could Raise Billions

According to President Biden, corporate stock buybacks should be taxed at a 4 percent excise rate during his State of the Union address. Companies who announce stock buybacks are telling the world that they do not have productive investments within their companies and would rather distribute the cash to their shareholders. By using tax revenue, the public can invest in schools, roads, and healthcare, among other things.

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In spite of the fact that the 1 percent tax only went into effect last month, early evidence indicates that it might generate more revenue than expected. Also, it appears that the tax is not high enough to eradicate the tax advantage of buybacks over other ways corporations distribute profits. Stock buybacks offer shareholders the same financial benefit as dividends in the year they are distributed, but they can be exempt from personal income taxes for years or even forever because they boost stock values. While the current stock buyback tax of 1 percent can reduce that disparity, it isn't enough to eliminate it.

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After a year of record profits, Chevron announced a $75 billion buyback program, and they aren't alone - many profitable companies have announced buybacks this year. During the first four years after former President Trump's corporate tax cuts became effective in 2018 under the Tax Cuts and Jobs Act, corporations that made the biggest investments in plants, equipment, and software that could have created new jobs and grown the economy were more likely to enrich their shareholders through stock buybacks.

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Buybacks are used by corporations for a variety of reasons

It is common for companies to purchase their own stock with cash holdings when they determine that it will enhance the share price or other financial metrics like price-earnings ratios, return on assets, and return on equity. For corporate executives whose compensation is often based on equity, and whose relationship with the board is greatly influenced by the performance of the stock, this can be a boon.

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Aside from that, it acknowledges that the corporation has few productive investments to make. In a situation where a company has large cash holdings, but few productive investments to spend the cash on, it may opt to distribute some of that cash to shareholders through dividends or buybacks in order to help them find profitable investments elsewhere. Embracing tax-favored distributions of cash through buybacks may be preferred by executives and shareholders over raising workers' pay and benefits.

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Dividends are tax-free when buybacks are performed

Regardless of the motivation for buybacks, shareholders should not receive a tax advantage for buybacks over dividends, since both achieve the same results. Dividends and dividends are effective ways for corporations to distribute cash to their shareholders. Shareholders pay income tax on their dividends, which are usually between 15 and 24 percent, based on the number of shares they own. A tax treaty typically reduces the rate to 15 percent for foreign investors who own about 40 percent of U.S. corporate stock.

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In stock buybacks, shareholders who sell their shares realize a capital gain (or loss) on the sale of their stock when the company buys its own stock. Typically, individuals residing in the U.S. owe a capital gain tax rate of 15 to 23.8 percent on capital gains. When foreign investors sell their shares, they are subject to capital gain taxes based on their country of residence—possibly very little or no tax.

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A tax disparity between dividends and buybacks occurs when shareholders do not sell their stock during the buyback. Increasing the value of the shares benefits the remaining shareholders when the number of shares is reduced. As a result of this rise in value, shareholders have to pay taxes on the capital gains, but the gains are not realized until they sell their shares, presenting two distinct tax advantages to U.S. shareholders.

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Firstly, shareholders can defer income taxes for years or decades by holding on to their shares. As shareholders' shares appreciate, they gain more wealth and purchasing power. It is not just about timing, but rather about generating even more income over time. In addition, shareholders may borrow against their assets, thereby effectively spending their income without paying income taxes.

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A second reason is that capital gains will escape taxation if shareholders never sell their assets. Currently, unrealized gains on assets passed down to heirs are not taxed. As a result of the stepped-up basis rule, heirs do not owe capital gains taxes until the gains have been realized after they have taken ownership of the shares. The heirs then owe capital gains taxes only on the gains accrued since they acquired the shares. There have been extensive reports on deferring capital gains taxes and stepping up basis.

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Similarly, foreign investors and foreign shareholders benefit. Foreign shareholders who hold onto their shares also benefit without paying dividend taxes. Capital gains can also be tremendously taxed in their country of residence if it has a very low rate of capital gains tax.

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In any case, stock buybacks should not receive favorable tax treatment over other methods of distributing capital to shareholders, whether they are used to distribute cash holdings or to replace productive investments and disproportionately benefit the wealthy. By creating this tax disparity, corporations are only able to maneuver their taxes, resulting in revenue loss for the public.

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The Inflation Reduction Act, which was passed by Congress, imposed a 1 percent excise tax on corporations that bought back their own shares. When Chevron carries out its $75 billion buyback plan under the new tax, it will be liable for $750 million in excise taxes.

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The buyback tax works in an indirect manner towards tax parity between buybacks and dividends. An excise tax of 1 percent is much lower than a tax rate of 15 to 23.8 percent on dividends. Corporations pay buyback excise taxes, which lower their total assets and reduce their share price, whereas individuals pay income taxes on dividends. While this does not completely eliminate the tax advantage for most shareholders, it does reduce the relative advantage of buybacks for foreign investors in countries with low capital gains rates.

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Shareholders who are not subject to tax are clear favorites of dividends due to the excise tax. A majority of US stocks are owned by these investors, who are primarily non-taxable retirement accounts. There was no tax advantage for these investors regarding dividends or buybacks before the excise tax was implemented.

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Any excise tax whatsoever on stock buybacks would be sufficient to curb their upward trend if taxable tax advantages are reduced and dividends are taxed clearly for non-taxable accounts.

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There has been no slowdown in buyback activity due to the buyback tax

It does not appear that buybacks are slowing down, even after the excise tax came into effect on January 1. As early evidence suggests, 2023 could be another banner year for buybacks. The Chevron announcement was followed by a $40 billion buyback plan announced by Meta (the parent company of Facebook). In January 2023, $132 billion in new buyback plans were announced.

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It is unlikely that an excise tax of 1 percent would substantially impact the tax disparity between dividends and buybacks if this trend holds throughout the year. While non-taxable investors now pay some taxes on buybacks compared to dividends that don't, they do so indirectly through a slight decrease in their stock value, which is difficult to quantify. Tax-advantaged investors continue to benefit from buybacks.

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It raises the question: To equalize dividend taxes with buyback tax, how high would the buyback excise tax need to be raised? The answer is impossible to give because different investors are taxed differently on dividends, and the excise tax reduces potential future earnings per share while dividend taxes do not.

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Parity can be achieved by Congress implementing the excise tax at the same rate that taxes on dividends generate. For the simplified assumption of a dividend tax rate of 15 percent for foreign shareholders and a dividend tax rate between 15 and 24.8% for taxable domestic shareholders, a buyback excise tax of about 10 to 12 percent would yield the same amount of revenue as a dividend tax on buybacks. As a consequence, non-taxable investors' preferences will shift to corporations that only issue dividends if this rate is set at this level. Tax-neutral excise tax rates would rise to the average dividends tax rate paid by all taxable investors if non-taxable accounts were disinvested entirely from companies engaged in buybacks.

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In 2018, Sen. Marco Rubio introduced a proposal to tax shareholders who benefit from buybacks as if they had received a dividend. This would be an alternative method of taxing buybacks. The shareholder would owe an imputed dividend tax upon the buyback instead of paying a capital gains tax upon selling their shares. As a result of the stepped-up basis rule, investors would no longer be able to avoid taxes entirely on dividends and capital gains. Foreign investors would also be taxed drastically more in the United States under this plan.

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It would be easier to tax buybacks as dividends with the Rubio proposal, but the structure is complicated. When the shares are sold, a proportional amount would have to be deducted from capital gains to calculate dividend tax. In other words, shareholders would be taxed twice on the buyback: first as a deemed dividend and then as capital gains.

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The President's proposed quadrupling of the excise tax rate on buybacks raises more revenue and cuts into the tax advantage buybacks have over dividends. A company admits they have few productive investment opportunities when they use its cash holdings to buy its own stock. In addition to infrastructure and schools, tax revenue can be used to create value for the entire economy.