Stocks were volatile with little change last week after a super strong July. Friday’s surprisingly strong employment elicited greater reaction in the bond market than the stock market. Good employment numbers are almost always good news for markets. After all, they signal a strong economy (despite two consecutive down GDP quarters!), but perhaps too strong given the 5%+ annualized increase in wages.
I don’t want to get into the technical debate as to whether a recession might have begun or not. Jim Vogt made the strong point Friday that we are not, given the strong employment report. But whether we are or are not in a recession, the central focus of monetary policy is to reduce inflation. In that regard, one can’t look at Friday’s report as good news. It’s great that gasoline prices are now closer to $4 than $5, But long-term inflation depends more on wage rate increases than gasoline price changes. There is much work still to be done. Last week, I suggested, wrongly, that a 75-basis point increase in the Federal Funds rate was off the table in September. It is very much on. There will be one more employment report before the FOMC meeting, but obviously more pressure to reduce the pace of economic activity is necessary to get the job done.
I want to switch gears and talk about one aspect of the President’s Inflation Reduction Act. Let me start by saying absolutely nothing in the bill is going to reduce inflation any time soon. The projected $300 billion reduction in the deficit over 10 years assumes that the Affordable Care Act subsidy expansion lasts for only 3 years. If extended for the full ten years, the reduction would be less than $100 billion assuming no inflation. Other than deficit reduction, nothing in the bill reduces inflation, but my point of discussing bill titles is a lead-in to the new bill’s imposition of a 1% excise tax on stock repurchases.
Let me start by quoting from the IRS. “Excise taxes are taxes that are imposed on various goods, services, and activities. Such taxes may be imposed on the manufacturer, retailer or consumer”. Does that fit with a 1% tax on stock repurchases? In my head, a 1% excise tax on stock repurchases represents a wealth tax more than an excise tax.
A company that generates free cashflow has four options. It can invest in its business, it can buy another company, it can buy back stock, or it can increase its dividend. Assuming the first two options are fulfilled, the choices are to buy back stock or pay dividends. The IRS prefers dividends. Both dividends and stock repurchases are paid after the corporation pays its own income tax obligation. The monies have already been taxed once. Dividends get taxed a second time at the individual level at a rate similar to what investors pay on capital gains. An “excise” tax on dividends would be an add-on to the tax shareholders already pay. That would include shareholders making less than $400,000 per year, a no-no in the Biden administration. A tax on stock repurchases is a stealth tax. Individuals don’t see it. It would be paid by the corporation. There are some corporations who borrow to buy back stock, mostly to help fund stock option plans given to employees. Most major buyback programs are designed to reduce shares outstanding, boost earnings per share, and elevate stock prices. After all, what is the goal of managements? To raise their stock price.
A 1% excise tax may seem inconsequential. It isn’t, but it’s impact would be relatively small. There will be some shift from stock buybacks to dividends but not too much. The IRS prefers dividends because they get tax payments on dividends immediately. The impact of stock buybacks only affects IRS receipts when the stock is sold. Corporate managements also prefer stock buybacks for two very different reasons. First reducing stock buybacks from one year to the next is hardly noticeable. Reducing dividends is very noticeable. The bigger reason may be that management and employees who control stock via options receive no dividends on their options. Therefore, stock buybacks at a proper price provide benefits to them while dividends provide none.
While a 1% excise tax may seem relatively inconsequential, what about 2%? Or 5%? Or 10%? Once Congress gets started taxing stock repurchases, when does it get to be too much, and economically destructive? I don’t have a precise answer. One only must look at the cigarette industry to see how excise taxes can be piled on over time. I am not equating the benefits of stock buybacks to consequences of smoking cigarettes, but I am noting that what starts with little notice can easily become economically harmful.
Corporations and shareholders already pay taxes on the income generated. Dividends are double taxed. Now share repurchases are going to be double taxed, taxed at the time the income is generated, and taxed at the time free cash is used to buy back stock. Will it be hurtful to economic values? There is only one answer…yes. Will the harm be consequential? Probably not at a 1% rate, but I would be willing to wager that the 1% wealth tax (not an excise tax) will only get larger over time.
Today Shawn Mendes is 24. Roger Federer is 41. Dustin Hoffman turns 85.
James M. Meyer, CFA 610-260-2220