What are stock buybacks? A finance professor explains why President Biden wants to raise the tax on this controversial use of corporate capital

Companies have been buying back their own stock at record levels – something President Joe Biden doesn’t care for. In his state of the union address, Biden said “corporations ought to do the right thing” and invest more of their profits in producing more goods and less in stock buybacks. To encourage them to do so, he proposed quadrupling the new tax on buybacks to 4%.

But what are stock buybacks, and why do some people consider them to be a bad thing? We tapped D. Brian Blank, who studies company financial decision-making at Mississippi State University, to fill us in.

1. What are stock buybacks?

Before we can answer that question, first we need to understand the basics of how stock works.

Stock represents an ownership interest in a company, such that stockholders have a stake in the business. Companies use stock as one way to raise capital by selling their shares to investors, usually in an initial public offering.

Most stockholders, however, obtain stock by buying it on a secondary market, like the New York Stock Exchange. In this case, one person chooses to sell their ownership in the company, while another person buys it.

As partial owners, shareholders see the value of their stock rise when the company does well.

One way investors can benefit from holding the stock is that some corporations pay dividends, which are payments made directly to shareholders. Another way that stockholders can benefit is by selling the stock for more than they paid for it. Together, this creates a return on investment.

And this brings us to share buybacks – and why investors like them.

2. Why do companies buy back their own stock?

When companies have extra capital, they might go into the secondary market and buy back stock from investors. This is often referred to as a stock repurchase or buyback program. Companies that are older and less focused on rapid growth tend to do them more often.

Companies do this for a variety of reasons, such as because they think their shares are undervalued and want to signal optimism to Wall Street, or because they simply want another way to distribute profits to shareholders – a key goal of any company – other than through dividends.

Shareholders like buybacks because companies often pay a premium over market price. And when companies buy their own stock, this removes it from the market, which has the effect of lifting share prices as supply goes down, benefiting existing stockholders.

It’s estimated that American companies bought back a record US$1 trillion of their own stock in 2022. And Apple is the biggest user of buybacks, having alone spent $557 billion over the past decade repurchasing its own shares.

3. Why do Biden and others dislike buybacks?

Critics like Biden contend that share buybacks represent short-term thinking that doesn’t actually create any real value. They argue instead that companies should use more of their profits to invest in more productive activities like business operations, innovation or employees.

Returning money that a company makes to stockholders does mean less capital is available for other investments. In his speech, Biden specifically called out “Big Oil” companies for using the record profits they’ve earned from high energy prices to buy back their stock rather than investing in new wells to increase supply – and help reduce gas prices.

But the decision whether to invest to increase domestic production is a complicated one. For example, the reason companies aren’t investing in new wells right now is not simply because they are buying back stock. The reason has more to do with how oil companies, and their shareholders, don’t think it is profitable to invest in more supply for a whole host of reasons, including the global push for greener energy by both policymakers and consumers, which is bound to reduce demand for fossil fuels in the future.

It’s also worth noting that while share repurchases are becoming increasingly common and controversial, they remain very similar to dividends, which don’t prompt the same concerns among politicians.

4. Would increasing the tax result in fewer buybacks?

The 1% tax on buybacks is actually brand new.

Congress passed the tax in 2022 as part of the Inflation Reduction Act. It took effect at the beginning of 2023 and only affects buyback programs of $1 million or more.

Usually when an activity is taxed, it happens less frequently. So, I expect the tax to nudge companies to spend less on buybacks and more elsewhere. While politicians intend more of the money to be used to invest in their productive capacity, companies may simply spend more on paying shareholders dividends.

Since the tax is new, it’s hard to evaluate its actual impact. Companies reportedly accelerated their repurchase programs in 2022 to avoid paying the tax.

But early data from 2023 suggest the 1% tax isn’t significantly deterring buybacks. Companies announced $132 billion in buybacks in January, three times as much as a year earlier and the most for the month on record.

Biden’s proposal to boost the tax to 4% may alter corporate behavior more. But again, it may just lead to greater dividend payments, not the other types of investments he and others hope for.

In addition, given that Republicans control the House, and Democrats have only a narrow majority in the Senate, this proposal has little chance of becoming law anytime soon.

The reasons why large corporations make the decisions they do about where to allocate capital – whether to build a factory, hire more workers or buy back stock – are complicated and, in my view, never taken lightly. These decisions have many facets and implications, and are not necessarily bad. I believe this is something worth remembering the next time you hear politicians saying “corporations should do the right thing.”