A financial transaction tax has the potential to change corporate incentives. Targeted at the largest US companies, the tax could be a catalyst to redirect profits away from share buybacks and into new investment, boosting productivity and growth in the wider economy.
Publicly traded firms are under pressure to deliver consistent returns to their shareholders, including through dividends and share buybacks. This often overshadows corporate investment in research and development (R&D), infrastructure and workforce development, despite the potential of each of these to improve firms’ performance and fuel long-term economic growth. It can also increase wealth concentration, with the rich more likely to benefit from higher share prices and larger dividends.
Buybacks boost asset prices by reducing the supply of shares in the market. They have become a common tool used by corporations to appease shareholders who require returns on their assets. Further incentives come from structures of executive compensation that are linked to asset performance.
Of additional concern is the fact that buybacks can be funded by debt, typically in the form of corporate bonds. This is financially risky, as buybacks do not help to boost a firm’s productivity or its ability to pay back debt. According to the International Monetary Fund, such risk-taking can also damage a firm’s credit rating, creating long-term instability. Analysts at JP Morgan have reported that up to 30% of the buybacks in 2016 and 2017 were funded by corporate bonds.
How might policy-makers discourage share buybacks?
One idea is tax. Imposing a financial transaction tax (FTT) would push up the cost of carrying out a share buyback scheme, making it more attractive for firms to spend profits elsewhere.
Buybacks have been slowing in recent months. The $175 billion spent by S&P 500 companies in the three months to June 2023 represents a 20% decline from the equivalent period last year. But this trend seems to be fuelled by rising interest rates, making it more expensive and riskier to use debt to finance buybacks. Profits, on the other hand, remain the prime source for funding buybacks.
The imposition of an FTT would add significant transaction costs to short-term speculative activities, such as high-frequency trading and share buybacks. This may cause firms to reconsider their investment strategies, making them more likely to put money towards more sustainable long-term activities, such as investment in infrastructure, human capital or R&D.
In this way, the tax could create financial incentives for firms to prioritise activities that contribute to innovation, economic growth and long-term value creation. In addition, if designed correctly, the FTT could differentiate between various financial transactions, imposing higher tax rates on short-term, speculative trades, and lower rates on long-term investments.
But some researchers have argued against this suggestion: they state that with an FTT, investment intensity increases alongside increasing proportions of net income spent on buybacks and dividends. Yet even in the numbers they use, the proportion going towards investment is small compared with other uses: 96% paid out to shareholders from 2007 to 2016, with a rise from just 1.9% to 2.6% on R&D spending. Further, over half the firms in the S&P 500 spent nothing on R&D in 2018, with just 38 of the 500 companies accounting for 75% of all R&D expenditure.
The researchers also state that cash stockpiles are robust and growing, giving firms greater ability to invest in long-term projects. But until this investment actually happens, this cannot be used to argue in favour of buybacks.
Similarly, they argue that accounting for equity issuances paints a less drastic picture. This is because deducting the income to the firm from issuing shares on the market or directly to employees from the total paid out to shareholders reduces the figure of 96% to 50%. Yet this deduction doesn’t translate into major increases in long-term investment.
Even if we lose, we win
It remains likely that making asset buybacks less attractive could be beneficial to the wider US economy. But getting the tax rate right is key. If it is set too low, such a tax is unlikely to change the behaviour of the largest corporations, and share buybacks will still be very attractive.
But that is not all bad news. The tax would still bring significant long-term investment in the economy. That’s because the tax revenue generated could (and should) be spent on other pro-growth policies. For example, the FTT proposed by US senator Bernie Sanders in his Inclusive Prosperity Act was estimated to have the potential to bring in up to $220 billion annually.
Implementing an FTT could reshape incentives in a way that benefits the long-term health of the US economy. The era of unequal share buybacks needs to end, with policy-makers using targeted taxation to promote a more equitable and prosperous society.