Rubio’s Smart Push to Change the Tax on Buybacks

(Bloomberg Opinion) -- The stock market dipped over Senator Marco Rubio’s proposal to change how investors are taxed when companies buy back shares. This knee-jerk reaction was unwarranted.

Rubio wants to treat corporate buybacks and dividends the same, tax-wise. Under the current code, buybacks create opportunities to avoid or defer taxes. When companies are deciding what to do with income they don’t plan to invest, they have an incentive to repurchase shares. Removing this incentive would be wise.

Exactly how Rubio would close the loophole remains unclear, and the issues are complicated. But he’s right to want to try. Buybacks are on the rise. Companies are using big portions of their savings from the tax overhaul in this way. Aggregate share repurchases rose almost 50 percent to $384 billion in the first six months of 2018, after the tax law was passed; for the full year, they hit a record $1 trillion.

This is troubling because research has shown that as companies increase their share repurchases, they’re less likely to prosper. This might be because firms are preferring buybacks not just to paying dividends, but also to undertaking profitable investments. When firms finance their buybacks by borrowing, the risk of disappointing results is all the greater. Defenders say repurchases let shareholders move capital to new ventures and away from companies that have exhausted their investment opportunities. That seems plausible in theory, but again the record makes you wonder: More money has been extracted by shareholders of nonfinancial publicly traded companies than has been reinvested through new equity issuance in 14 of the last 15 years.

Ending the preference for buybacks would also help to address an unfair advantage enjoyed by some of the wealthiest taxpayers. Right now, major shareholders like Mark Zuckerberg who own stock in companies that use repurchases exclusively can defer their own tax, and their heirs can avoid taxes altogether (thanks to a loophole in the tax code known as a step-up in basis).

Rubio wants to use the revenue from increasing taxes on buybacks to pay for extending a temporary provision of the tax law that lets companies fully and immediately write off certain investments. This idea too has merit. Granted, making full and immediate expensing permanent raises questions about the cost, but after the initial years the revenue loss drops, and it could well be offset by stronger economic growth.

Some of the resentment over corporate buybacks, part of a wider drive toward taxing capital and high incomes more heavily, is overdone. So long as companies are competing fairly, they should be allowed to run themselves and return income to shareholders as they think best. That is why Rubio’s proposal makes more sense than an effort by Senator Chuck Schumer and Senator Bernie Sanders to block buybacks unless the companies meet certain labor and corporate-governance standards. If those standards are sound, they should be imposed evenhandedly and through regulation, not by tweaking the rules on financial engineering. The problem with the tax code as it stands is that it isn’t neutral: It distorts managers’ decisions in an unintended way – with results that haven’t been good.

Rubio is right. The rules should be changed to put dividends and buybacks on a level footing.

Editorials are written by the Bloomberg Opinion editorial board.

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