Goodbye Buybacks, Hello Dividends?

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. What could a proposed 2% excise tax on corporate stock buybacks mean for investors? Joining me today to discuss the topic is David Harrell. David is an editorial director with Morningstar Investment Management and editor of Morningstar DividendInvestor.

Hi, David, thanks for being here today.

David Harrell: Thanks for having me.

Dziubinski: So let's start with the basics. Buying back stock is just one thing that a company can do with their capital. What are some of the other things that companies can do?

Harrell: Profitable companies--they can do several things. A company could could invest in itself, in R&D, a manufacturing company might build a new plant, a company that had borrowed, say, a fair amount of money for an acquisition might want to use some of those earnings to pay down that debt. But finally, companies can return cash to shareholders, and they have two primary ways of doing that. One is dividends, either the regular dividend or special dividend. The second is to repurchase or buy back its own shares.

Dziubinski: Now, stock buybacks have been pretty popular during the past several years. Why is that?

Harrell: They weren't always popular. Up until 1982, when you had a rule change from the SEC, companies who bought back their own shares had to be careful of not being charged with stock price manipulation. But since then, they've become increasingly common. And after the tax cut of 2017 went into effect in 2018, we saw a huge increase in the dollars companies were devoting to buybacks. And one reason is that it's essentially a tax-free way of returning cash to shareholders. With dividends, obviously, you receive a check from the company or the cash shows up in your brokerage account. And unless it's a tax-deferred account, or your AGI is low enough, you're going to pay taxes on those dividends.

With buybacks, you benefit in a more indirect way. So you're not actually receiving cash from the company, but when a company buys back its shares and retires their shares, it's essentially spreading its earnings over fewer shares at this point. And if you think about a single share of a stock as a slice of that company, or at least a slice that entitles you to a portion of its earnings, every share is equal to a slice. Now if you've always sliced your pizza into eight slices and now you're slicing it into six slices, each slice is a little bit bigger. So, your earnings per share, assuming the earnings remain stable, is a little bit higher. And if the multiple remains the same, you're going to see an increase in the share price. But this is simply a paper profit. So until somebody sells those shares, no taxes are paid on that increase.

Dziubinski: Got it. Let's talk a little bit about the current proposal that's out there. Unpack it for us.

Harrell: Sure. So last week, two Democratic Senators--Wyden of Oregon and Brown of Ohio--put out a proposal that called for a 2% excise tax on share repurchases by companies. And so if a company bought back shares, except for the purpose of an employee retirement plan or employee stock compensation, they would pay a 2% excise tax. So if a firm bought back a $1 billion of its stock, it would pay a $20 million excise tax on that transaction.

Dziubinski: So if this does go through, and there is this excise tax levied, are companies going to be rethinking buybacks?

Harrell: I'm not sure. I mean, in theory it makes buybacks slightly less attractive on paper. But I don't know if a 2% excise tax is really enough to influence corporate behavior. I think the most likely result--and again, we don't know yet any details ... this was a four-page proposal that was very light on the details of actually how the tax would be collected--but I think the most likely outcome is companies might simply just nudge down the buyback amount a little bit so that their total outlay was the same. So instead of $1 billion dollars in buybacks, they'd buy back a little over the $980 million, and then the 2% would add up to the same amount that they had originally intended to spend on buybacks.

Dziubinski: Do you think this could lead to, you know, if this tax becomes a reality, could we see some dividend increases as a result of companies shifting gears or ....?

Harrell: Well, a couple things. First of all, this proposal was released last week. And then on Monday of this week, Democrats released details of their tax plan, and they didn't include the buyback tax in that, which makes me think it's less likely to become a priority and to happen in the near term. But getting back to the dividend question. You know, if you look at the criticisms that have been made about companies buying back their stock in recent years, a lot of that's been directed at firms that don't even pay dividends at this point. So, I think that a 2% excise tax is very unlikely to then nudge those firms to say, "Instead of buybacks, let's initiate a dividend." I think it's more likely they'll simply, you know, make the buybacks in a way at a slightly lesser amount, or they can even just sit on the cash instead of doing that.

Dziubinski: Well, so it might not be great news for dividend seekers, huh?

Harrell: No. Yeah, I mean, it's tough to say, but it really comes down to the intent. And if you look at the press release that went out with a proposal last week, they were pretty explicit in that they were trying to affect corporate behavior but not to increase dividends but to try to encourage companies to instead of using that cash for buybacks to reinvest it in themselves and their workers. You know, I will point out that this was two Democratic Senators making this proposal. But we've seen this on both sides of the aisle. And in 2019, Sen. Marco Rubio of Florida was calling for taxation of buybacks, and he was calling for them to be taxed at the same rate as dividends to make it sort of neutral. So clearly, even though I think it's unlikely that we're going to see anything in the near term, I wouldn't be surprised to see the idea brought up again in the future.

Dziubinski: Well, David, thanks for your perspective on this. We appreciate it.

Harrell: Thanks for having me.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.