The Biden administration’s new stock buyback tax will have little impact on the overall stock market. It might even actually help it. I’m referring to the new 1% excise tax on share repurchases that went into effect on Jan. 1.
This tax has set off alarm bells in some corners of Wall Street, on the theory that buybacks were one of the biggest props supporting the past decade’s bull market — and anything weakening that prop could lead to much lower prices.
Even more alarms went off after President Joe Biden telegraphed his intent to quadruple federal taxes on buybacks, to 4%.
While this proposal is considered dead on arrival on Capitol Hill, the focus on possibly increasing this tax from 1% reduces the likelihood that it will be eliminated anytime soon.
Tax applies to net repurchases
Yet stock-market bulls shouldn’t worry. One reason is that the new excise tax — whether 1% or 4% — is applied to net buybacks — repurchases in excess of how many shares the corporation may have issued.
As has been widely reported for years, the shares that many companies are buying back often are barely enough to compensate for the new shares they issue as part of their compensation of company executives. As a result, net repurchases — on which the new tax will be levied — are an order of magnitude smaller than gross repurchases.
The chart below provides the historical context. It plots the S&P 500’s divisor, which is the number used to divide the combined market cap of all component companies to come up with the index level itself. When more shares are issued than repurchased, the divisor rises; the reverse causes the divisor to fall.
Notice from the chart that, though there have been some year-to-year fluctuations in the divisor, the divisor’s end-of-2022 level was virtually unchanged from where it was at the top of the Internet bubble.
There is much irony in the excise tax’s application to net repurchases. Much of the political rhetoric that led to the creation of the tax was based on the complaint that companies were repurchasing their shares simply to reduce the share dilution that would otherwise occur when executives are given shares as part of their compensation packages. But it’s precisely when share repurchases equal share issuance that’s the tax would not apply.
The buyback tax might encourage higher dividends
The reason why the new tax on share repurchases might actually help the stock market traces to the impact it could have on companies’ dividend policy. Up until now, the tax code provided an incentive for firms to repurchase shares rather than pay dividends when they wanted to return cash to shareholders. By at least partially removing that incentive, companies going forward may turn to dividends more than they did previously. The Tax Policy Center estimates that the new 1% buyback tax will lead to “a roughly 1.5 percent increase in corporate dividend payouts.”
This would be good news because, dollar for dollar, a higher dividend yield has more bullish consequences than a higher buyback yield. (The buyback yield is calculated by dividing per-share buybacks by share price.) To show this, I compared the predictive abilities of either yield. I analyzed quarterly data back to the early 1990s, which is when the total volume of buybacks in the market began to be significant.
The accompanying table reports the r-squareds of regressions in which the different yields are used to predict the S&P 500’s return over the subsequent 1- or 5-year periods. (The r-squared measures the degree to which one data series explains or predicts another.) Notice that the r-squareds are markedly higher for the dividend yield than for the buyback yield
|When predicting S&P 500’s return over subsequent 1 year||When predicting S&P 500’s return over subsequent 5 years|
The bottom line? While the new buyback tax is unlikely to have a huge impact on the stock market, the impact it does have might be more positive than negative.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com