Listen to the podcast:
Fueled by the lower corporate tax rate, share buybacks among S&P 500 companies shot to a fourth consecutive record in the last quarter of 2018, according to Standard & Poor’s. What’s more is that the lower tax rate enabled dozens of profitable Fortune 500 companies such as Amazon and IBM to avoid paying federal taxes last year, according to the Institute on Taxation and Economic Policy. Tax cut proponents had argued that companies would have more money to reinvest in growth and expansion, and eventually benefits would flow to employees and the economy overall, but critics say those effects so far have been limited.
Corporations like buybacks because they reduce shares outstanding and boost earnings per share, typically leading to higher stock prices — a boon for investors and also for executives, who often earn most of their compensation through stock options or grants. In the first three quarters of 2018, stock buybacks rose 52.6%, while capital investment increased 8.8% and research and development went up 12.5%, according to Forbes. The large amount of tax savings devoted to buybacks prompted Senators Bernie Sanders and Chuck Schumer to say they plan to introduce legislation to ban the practice unless a firm first makes investments in workers and communities.
To help understand these recent dynamics, the Knowledge@Wharton radio show on SiriusXM invited Wharton finance professor Jeremy Siegel and William Lazonick, a professor of economics at the University of Massachusetts at Lowell, to offer their views. (Listen to the podcast at the top of this page.)
An edited transcript of the conversation follows.
Knowledge@Wharton: What has been the impact on Wall Street from this run of buybacks?
William Lazonick: This has given confidence to those who can make money from buybacks — the companies are going to do them; [some are] even borrowing money to do them. Now they have extra money from repatriating profits from abroad. But that certainly didn’t start this phenomenon. The phenomenon started in 1984, which is about a year after the SEC basically adopted an under-the-radar rule called 10b-18 [that provided a ‘safe harbor’ for companies to do buybacks], which we call a license to loot.
It basically said that in addition to paying dividends, which have not gone down but which have gone up, and which is a way that you reward shareholders for just holding shares, we are going to let you go on the market through open market repurchases and basically manipulate the stock price. But we’re not going to call it manipulation, and we are going to give you a safe harbor against manipulation. … And we won’t even monitor if you are doing that.
So, this is a phenomenon that has been going on for over three decades. I know Jeremy Siegel, I’ve read his book, Stocks for the Long Run. This is not stocks for the long run, and I actually noted in the various editions of his book that he wasn’t dealing with the problem of stock buybacks, which I found curious. Because [starting] in 1997, buybacks as a mode of distribution to shareholders became greater than dividends.
Regarding open market repurchases, the people who are going to make money from them are the people who can time the buying and selling of shares, which is not you or me. It is people who either have the information to do so, which is certainly top executives. And we don’t even know the days on which buybacks are done, at the time or after the fact. The SEC doesn’t know.
“It is not necessarily that the buybacks are impeding them from making other types of investments, but it leads to behavior that actually undermines their competitive capabilities.” –William Lazonick
[Others who make money from stock buybacks] are hedge fund managers, investment bank managers … and really that’s their business. They time the buying and selling of stocks. It might be very short term, but it might be holding stocks of a company, even as Carl Icahn did for three and a half years. And then pull out two billion dollars from the investment without ever actually giving Apple anything, and this is in the case of Apple a few years ago. You find lots of examples of this.
So that is the problem, on the one side, and the other side is the companies that are doing it typically have lots of money, at least at the time they are doing it. So it is not necessarily that the buybacks are impeding them from making other types of investments, but it leads to behavior that actually undermines their competitive capabilities. You have to dig into particular companies, particular industries to see how that works.
Jeremy Siegel: Well, I disagree. I don’t know what you mean, “licensed to loot.” Buybacks proliferated for two reasons. One is our tax code, which is more lenient on capital gains than on dividends, and therefore, if you return profits as capital gains rather than dividends the ultimate investor gets a lower tax bill.
Another reason for the increase in buybacks is the incentives that are given both to employees and to management. These options are based on the price of shares. And therefore if you return profits to shareholders by means of raising [the stock] price instead of dividends, this benefits those that are granted options on that.
By the way, both those causes of the preference for buybacks could be very easily neutralized by some simple changes in the tax code, that unfortunately were not made in the latest tax revisions last year. There is a big hole in what they could have done to prevent those buybacks. But right now the tax code and the option incentive is by far the major reason for the increase in buybacks.
Knowledge@Wharton: How could the tax code have been changed?
Siegel: One thing they could have done to put the tax on dividends on the same footing as capital gains, is that anyone who reinvests their dividends — in other words joins a stock reinvestment plan, which is very easy to do, you just indicate that with your broker — would not pay tax on his or her dividends if it is reinvested until they finally sell the stock.
That is exactly what happens with capital gains. You get capital gains, you are not taxed until you sell the stock. That would put the dividend on the same tax status as the capital gain. As far as options are concerned, there could be a ruling that the options should be dividends plus capital gain. Not just on the price of the stock, but you would add back any dividends. So that would mean that a company that gave a dividend rather than buying back their stock, they would still get that preference on their options.
So it is called price cum dividend options, that you add back the dividend [the buyer of a stock will receive a dividend that has been announced but not yet paid out]. And there are some options out there [like that]. They are not as popular, but if they mandated those options for the management, then the management would say, “well then, I could give a dividend without being disadvantaged on my option.”
Lazonick: I disagree. First of all, qualified dividends get the equivalent capital gains rate, depending on your tax bracket. And most corporate dividends are qualified. Secondly, the executive pay, the gains that the executive would make when you get a price boost from buybacks, and their stock options — the stock price goes up. They exercise the option and sell the stock, or their awards vest often on metrics that are based on stock price.
They don’t pay capital gains tax, they pay ordinary taxes. In fact, the problem of capital gains taxes on stock options is something that Congress got rid of in 1976, that prevailed between 1950 and 1976. And that was a tax dodge when you had very high marginal tax rates on ordinary income, as high as 91%, and a 25% capital gains tax rate, at least in the 1950s and 1960s.
So that is an old phenomenon that actually people recognized at the time was a scam, and they got rid of it in 1976. Options came back after 1981 because of the rise of Silicon Valley and giving broad-based stock options to employees.
“Those causes of the preference for buybacks could be very easily neutralized by some simple changes in the tax code, that unfortunately were not made in the latest tax revisions last year.” –Jeremy Siegel
The gains are all taxed at the ordinary tax rate. In fact, it is in the Economic Recovery Act of 1981 that in any one year the most you can take as capital gains rate on options is $100,000 of exercisable options. So if the stock price doubles you might make $100,000 extra, which would be fine for me, but that is typically for executives. And in fact the problem then is if you have qualified stock options where you can get a capital gains tax rate, and it is limited, you have to hold the stock for a year.
Executives now can sell the stock the second they buy it. In fact they get taxed on it the second they exercise the stock option. And there is a risk to them if they hold the stock. They could hold the stock, it’s up to them, but they already paid taxes at that time at the ordinary rate on this stock that is exercised.
Now up until 1991 … insiders, and this still exists, have to wait six months after a certain date before they can sell the stock, or they have to give the gains to the company. Until 1991, that date was the exercise date of the options. And so executives then had to wait six months before they could sell the stock. They lobbied against that, and the SEC changed the date at which that six months started to the grant date. And since all stock options have at least a year to divest they can sell them right away. So that’s absolutely wrong.
In terms of stock options they are a very bad way of paying people, because they get huge amounts of money even when the companies go downhill. And I just have an article coming out on Boeing, and the $95 million that this guy [CEO Dennis] Muilenburg has pulled in, in his take home pay since 2015, 2016, 2018. Well they did $43 billion in stock buybacks. They could have built four whole new planes better than the 737 for that at least.
And they are getting all of these gains even when they are doing things that result in failure. We have all of this evidence on the pharmaceutical companies that are charging us high prices, saying that they need higher prices to invest more in drug innovation. And Merck and Pfizer have been for a couple of decades now paying 150% of their profits out as dividends and buybacks, and increasingly buybacks. They don’t need those high prices that we are paying.
So I am paying high prices for drugs, or for the insurance premium. And these guys are stuffing all of that money in their own bank accounts. And meanwhile we are paying as taxpayers $30 billion to $40 billion a year in NIH [National Institutes of Health] funding that benefits them. And they have a whole business, as all of these companies do, of avoiding taxes. So you can put a little spin on this by not looking at what is going on in the companies. But if you look at what is going on in the companies, you see that the whole thing is rotten and it is a license to loot.
“Reinvesting is not simply investing in plant and equipment, it is investing in people.” –William Lazonick
Siegel: Well first of all I am sorry but you are completely wrong on the qualified dividend question. Yes, the tax rate is the same, but it is the deferral option on the capital gain that I refer to. So capital gain does have the same rate, but the deferral of the capital gain tax versus the immediacy of the tax on the dividend.
Lazonick: That’s a tweak it sounds like.
Siegel: That is a major factor for a lot of people.
Knowledge@Wharton: What do you think is the impact on Wall Street from the increase in stock buybacks?
Lazonick: Well, I don’t care about Wall Street, I care about workers. And I care about people who then go and vote for Donald Trump because they have been ignored for three decades and they don’t have jobs. The way in which we create employment opportunities — and I don’t mean just hiring someone for a day or a week, I mean, for 10, 20, 30 years — and whether it is the same company or a different company, is by those companies reinvesting their profits. That is the foundation of corporate finance. And that is what hasn’t been going on.
And part of that reinvestment is not just plant and equipment, because any company can buy plant and equipment. It is training, retaining and rewarding employees. And so if you are going to get an upward movement in wages, it is because companies are more productive, and they reward the value creators. By the way, the value creators are mainly the workers.
People like you or me who would just buy shares in a company, we’re not investing. That is a myth. All we are doing is buying and selling shares. It is the workers who produce the value, put the money back into the company, get higher wages that historically gave us a middle class. And that is what is missing. So there is much deeper problems here than Wall Street. Wall Street is a problem. But I am not worried about Wall Street … I am worried about Main Street. I am worried about what is going on in the companies where 100 million people are working and trying to make a living every day.
Siegel: I never believed the idea that this money that was going to be repatriated was going to go into investment — ever. Exactly what I thought would happen did happen. Before the 1980s firms used to pay out two thirds, 70% to 80% of their profits as dividends. Then when the stock buybacks came in, they just cut their dividend and substituted buybacks. So you only get a 2% dividend yield, well before then you got a 4% yield. And now they buy back 2%. The truth is firms didn’t really need to invest more; they were producing everything that they needed to. There were no supply shortages and suddenly they needed to invest. So they are going to get greater corporate profits as a result.
The main thing was to lower that tax rate to the same level as the rest of the world and to prevent the inversions that were taking place. That to me was a big gain. Then there were other big gains in terms of corporate tax, in terms of how you do it. We can talk about expensing versus the other [methods], but basically we had the very high tax rate and now statutorily it is down to about the average.
Lazonick: First of all it’s not true that companies traded off dividends for buybacks. All of the data that we have shows that dividends have increased even as the proportion of profits and buybacks have been on top of them. We look at the same companies going back to before 1982, and buybacks were minimal, and we can show that for even the same set of S&P 500 companies.
That data is all available online and in various kinds of articles, and it is well-documented. The other thing, the notion that companies had nothing else to do with their money, that is the problem. We know that real wages of most workers have stagnated for about three decades. We know that job stability has been undermined. That there is actually downward mobility for whole groups of the population. And that is because corporations stopped reinvesting in their companies.
“It is not the responsibility of corporations to teach students how to read, write, add, and subtract.” –Jeremy Siegel
Reinvesting is not simply investing in plant and equipment, it is investing in people. People through time are the ones who get experience. Even people who have what we might think are pretty ordinary jobs. Their experience is very important to productivity because it is all part of an organization, a process. And that is what you need to study. And that is where the impact is.
The impact is on what workers get paid, the experience they get, the productivity we have. … The U.S. is losing competitive advantage in so many industries, and now we have China on the horizon. But this goes back, of course, to the rise of Japan. And Japan is center stage, it is still much more productive than a whole lot of areas in the United States. To say that this had no effect, there wasn’t anything to invest in, is just to ignore what has happened in American industrial history over the last three, four decades.
We see it in income inequality, we see it in concentration of income at the top, we see it in stagnating wages, downward mobility. And so give me explanations of that, without buybacks.
Siegel: There is a very easy explanation of that. The workers aren’t productive mainly because our educational system totally failed. You say the only way we should educate people is through the corporations paying for their training? You know there has been a total collapse in educational standards over the last 30 years. How about our school system?
Lazonick: You’re absolutely right. The school system has failed. But we had very high tax rates, progressive tax rates in the era before the 1920s, before this change in companies. And we educated our labor force, we had free higher education. We stopped investing in this because the elite decided that they didn’t need the educated labor force.
I could go on for hours about that, because we are just coming out with a book on this whole process and what has happened to African-American employment over the last 50 years. You could write the same thing about Hispanic employment. We got very fortunate in the United States in the high tax yield that Asia was investing in education and labor force. And we had selective immigration policies to our benefit, and to the great benefit of the people who may be able to make use of them, that have given us an Asian-American labor force that is highly productive. And in many ways unfortunately — not to the fault of Asian Americans, because they were taking advantage of the opportunities that I think anybody would want to take advantage of — but we have competitiveness in certain high tech fields, because we have an educated labor force, the origins of which we did not educate.
And at that point our American elites said, ‘well we don’t need to worry about educating the labor force, upgrading the educational labor force.’ And I can tell you something from the book we are just finishing on what has happened to African-American employment, what has happened, what you see now, people like Angus Deaton have documented in terms of the downward mobility of workers with a high school education because their education was downgraded.
It happened to blacks first, and then it happened to white people because the whites did not take care of the blacks. Okay, so these are big socioeconomic problems, but the corporation is absolutely at the center of it. The corporation isn’t just some disembodied entity. These large corporations — about 1,900 corporations account for about 34% of business sector employment, 38% of payrolls, 44% of revenues — what those companies do or do not do affects the whole way in which the economy works.
So if you don’t understand how those corporations are making money and what they are doing with that money, then we don’t understand taxation, we don’t understand investment in education, we don’t understand a whole bunch of things. And what we start understanding when we understand that is how we get the kind of politics that we have now. … You can’t paper them over by saying, well stock options are good or bad. These are central to the way these companies operate.
Siegel: It is not the responsibility of corporations to teach students how to read, write, add, and subtract. Period.
Lazonick: It’s the responsibility of corporations to pay taxes.
Siegel: Yes, there is a terrible failure — our educational system.
Lazonick: I am afraid you’re wrong. The people … who run companies, who determine allocation of resources — it is their responsibility to pay fair taxes, and they have whole divisions set up to avoid taxes, and we let them do it. They’re doing what we let them do, but we have to change what corporations are permitted to do.