A popular political inflammatory is to cast corporate tax cuts as a scam that only feeds stock buybacks.
“Corporations have been pouring billions of dollars into stock repurchasing programs, not significant wage increases or other meaningful investments” that“…benefit primarily the people at the top” and come at the expense of “worker training, equipment, research, new hires, or higher salaries.” – Chuck Schumer
He is wrong. Let’s reverse engineer…
Share buybacks and dividends get cash out of companies that don’t have worthwhile ideas and into companies that do. An increase in buybacks is a sign the tax law and the economy are working.
Buybacks do not automatically make shareholders wealthier.
Company A has $100 cash and a factory worth $100
It has issued two shares, each worth $100
The company’s shareholders have $200 in wealth
Imagine the company uses its $100 in cash to buy back one share. Now its shareholders have one share worth $100, and $100 in cash. Their wealth remains the same.
Wouldn’t it be better if the company invested the extra cash? Perhaps. But maybe this company doesn’t have any ideas worth investing in. Not every company needs to expand at any given moment.
Company B has an idea for a profitable new venture that will cost $100 to get going
The most natural move for investors is to invest their $100 in Company B by buying its stock or bonds. With the infusion of cash, Company B can now fund its venture.
The frequent rise in stock price when companies announce buybacks proves the point. In my example:
Company A’s share price stays fixed at $100 when it buys back a share.
But suppose before the buyback investors were nervous the company would waste $40 of the $100 cash.
Imagine an overpriced merger or excessive executive bonuses. Not every investment is wise
The $100, stuck inside Company A, would be valued by the market at $60, and the company’s total value would be $160, or $80 a share. If it spent the $100 to buy back one share, the other share would rise from $80 to $100, the value of its good factory. When a company without great ideas repurchases shares, the price of the remaining shares rise. This stock price rise is no gift to shareholders. It is just the market’s recognition that $100 has been saved from inefficient investment.
The debate over whether companies will spend higher revenues on wages or buybacks misses the whole point. The economic argument for the corporate tax cut is that companies with good ideas, projecting a better after-tax return on new capital investments, will make such investments.
This new investment will let companies expand and make their workers more productive. When that happens, companies will compete for workers, leading to higher wages. Not all companies should make new investments, and some of the best investments come from new companies that don’t have profits yet.
h/t James Cochrane