The Senate-passed Inflation Reduction Act (IRA) calls for a new 1 percent excise tax on stock buybacks, the argument being it would be better for the economy if firms invested their surplus cash in the business, rather than returning this value to shareholders. However, research suggests that buybacks do not hinder investment opportunities, and actually help support a dynamic economy.
When firms have excess cash, they can either retain it or return it to the shareholders. One method of returning this value to the shareholders is through a dividend payment, which is usually paid at a scheduled frequency. However, firms can also repurchase the shareholder’s stock. In general, when firms opt to return value to shareholders, it is because they have exhausted all potential investment opportunities. To put it another way: Firms are not distributing cash in lieu of investment, but rather after they have already made their investments. This is why older, mature firms tend to issue dividends whereas younger, growth-oriented firms are more inclined to reinvest their earnings.
Shareholders that receive income from a stock repurchase can use their cash either for consumption or to pursue new investment opportunities. The latter is what drives economic growth. In this sense, stock buybacks enable investors to fund smaller firms and start-ups where the opportunities for growth and innovation can be much greater than that of established firms.
Research indicates most stock repurchases are recycled into other investments, with one study finding that nearly 95 percent of the funds from repurchases are reinvested in other public companies. One reason may be the wide use of retirement accounts, which hold the majority of corporate stock. As early withdrawals from these accounts are often subject to tax penalties, much of the cash received by shareholders tends to be reinvested, rather than used to finance immediate consumption.
The new stock buyback tax could potentially interrupt or distort this rather efficient and beneficial process of recycling investable funds, depending on how firms react to the tax. One potential reaction is that firms increase their dividend payouts instead of repurchasing a stock. Based on research from economist James Porteba on corporate payout policies, the Tax Policy Center estimated that a 1 percent tax rate on stock buybacks could increase dividends by about 1.5 percent. To the extent total payouts to shareholders are unaffected, the new tax may have little impact on the efficient allocation of capital.
Such a shift from buybacks to dividends could have an impact on the revenue-generating possibilities of this policy. Currently, we estimate that the stock buyback tax would raise about $55 billion in revenues over the next decade. However, to the extent that the firms shift to dividend payouts instead of stock repurchases, the tax could generate even less revenue over time, especially if those dividend payouts are largely remitted to tax-preferred retirement accounts. This would decrease the IRA’s long-run ability to reduce deficits.
Overall, the new buyback tax introduces uncertainties and potential downsides in terms of the efficient allocation of capital. With inflation still running high and the economy showing some signs of slowing, now is not a good time to try out a new tax of this nature.