The Tax Reform Act passed last December was good news for Corporate America. Tax rates on profits earned at home dropped from 35% to 21% and levies on lower taxed foreign earnings were significantly reduced. But the biggest near-term positive impact may come from the provision that reduced taxes on cash balances held abroad to a low 15.5% rate. This “repatriation” tax could be imposed on as much as $2 trillion in accumulated overseas earnings.
Architects of the latest tax reforms had at least two objectives in mind when crafting policy. First, they wanted to bring U.S. corporate tax rates more in line with those of our international competitors. Second, they hoped to give the economy a boost by stimulating productivity enhancing investments. Lowering the cost of bringing funds back home, it was hoped, would do just that.
Unfortunately, as of today it remains unclear how much cash will end up back on our shores and how the money that does return will be spent. In a recent survey of S&P 500 executives, BofA Merrill Lynch found that only 35% of total repatriated cash is likely to be spent on capital spending. Almost 75% is expected to be returned to shareholders in the form of dividends and share buybacks (see chart below.) Over the past month alone, American companies have announced more than $178 billion in share buybacks, the largest amount ever in a single quarter.
This current buyback binge is drawing criticism from many quarters. One complaint is that buybacks are nothing more than a ploy by management to boost compensation. Buying back shares reduces the share count which can, in turn, boost earnings per share. While compensation structures can impart bias, benefit consulting firm Equilar reports that only one-third of corporate boards use earnings per share to determine executive pay. Further, many companies such as Apple, repurchase shares simply as a way to offset the dilutive impact that results from employees exercising stock options.
Critics also claim that buybacks have historically drawn funds away from other productivity enhancing investments. The research supporting this claim, however, is not compelling. Harvard professors Jesse Fried and CV Wang recently examined the amount of funds returned to shareholders in the form of buybacks and dividends over the 2007-2016 period. After adjusting for additional share issuance and taking into consideration R&D spending, they found that shareholder payouts amounted to just 33% of adjusted net income.
The rush to buy back shares today, however, should be viewed critically for two other reasons. First, management should repurchase shares when they have available cash and when they perceive them to be undervalued. Unfortunately, the historical record here is not great. As the chart below shows, the volume of share buybacks tends to peak at market highs and decline precipitously when share prices fall.
Second, over the last decade companies have loaded up on low cost debt – in many cases borrowing funds for the sole purpose of repurchasing shares. This approach makes sense as along as conditions remain as they are today. But if rates rise or the economy softens, two very possible outcomes, elevated debt levels could swiftly become a problem. Deleveraging in a soft economy when cash flows weaken or in a rising rate environment will not be an easy task.