Not long ago, BlackRock boss Larry Fink wrote a really good McKinsey essay about the plague of “short-termism” in both the public and private sector. The former is perhaps more obvious than the latter, what with America’s massively unfunded entitlement system, inadequate infrastructure, and anti-investment tax code. But Fink didn’t spare Corporate America, focusing on the trend of companies choosing to return cash to shareholders — either as dividend payouts or share buybacks—rather than reinvesting those funds in research or new capital equipment. Fink seems to see both activist investors and the tax code as complementary factors driving this trend:
This wholesale return of cash to shareholders helps explain why equity markets are outpacing the economy. In the short run, we are rewarding shareholders, which causes the stock to spike. But to the extent that those cash expenditures starve corporate investment, the economy suffers. In particular, people who are riding the current wave will pay for it later when the ability to generate revenue in the long term dries up because of the lack of investment in the future.
It’s hard for even the most dedicated CEO to buck this trend. I do believe most CEOs would rather be making investments for the long-term growth of their companies. I don’t think they’re all motivated just to protect their jobs, but the government is not providing an environment that encourages those very long-term investments.
We should be using the tax code to change this behavior, not reinforce it. For example, another form of short-termism that makes it difficult for companies to focus on long-term strategy is the constant pressure to produce quarterly results. Where does that pressure come from? It comes from investors who are renters, not owners, who are going to trade your stock as soon as they can pocket a quick gain—or sooner if there’s no such gain in the offing. But what if we made three years rather than one the holding period necessary to qualify for capital-gains treatment and at the same time brought down the capital-gains tax for each year an investor held, perhaps reducing it to zero at the end of ten years? And on the other end, what if we taxed capital gains at an even higher rate than for ordinary income if the stock was held for less than six months? These measures could quickly help to enlarge the population of engaged investors willing to ride out short-term slumps to better position the company for the long haul.
The buyback issue is one that Washington is aware of, as a new Goldman Sachs note points out:
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.
What might the politicians do? Well, the Fink solution of tinkering with investment tax rates doesn’t seem to be in play. Some Democrats, such as Elizabeth Warren, want the SEC to consider changing its 1982 rule giving companies “safe harbor” to repurchase their shares without being charged with stock manipulation. Another possibility would be to alter corporate income tax provisions. Goldman notes that some buybacks are funded by debt issuance, and debt interest is tax deductible. In addition, “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.” Some Democrats want repeal the tax deductibility of “performance-based” pay in excess of $1 million per year.
The politics here could get more interesting during the presidential campaign, and when the Obama White House nominates two SEC commissioners. Then there’s the question of whether fewer stock buybacks would actually boost investment. Goldman calculations suggest the effect is “unclear” but “seems likely to be small.” Here is how the firm figures it:
… 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.
Some related reading:
— “The Repurchase Revolution” – The Economist
— “As Activism Rises, U.S. Firms Spend More on Buybacks Than Factories” – WSJ
— “Profits Without Prosperity” – HBR
— “How American businessmen are ruining American business — and the U.S. economy” – The Week
— “Buybacks and the parallel universe of bankers” – FT
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