The Great Resignation and the Labor Shortage

Why we need to tax stock buybacks and close the carried interest loophole.

BY JOHN MILLER | September/October 2022

This article is from Dollars & Sense: Real World Economics, available at http://www.dollarsandsense.org

issue 362 cover

This article is from the
September/October 2022 issue.

What Sen. Kyrsten Sinema giveth, she taketh away. That’s the main conclusion from the tax bargain she struck over changes in the misnamed Inflation Reduction Act. Ms. Sinema nixed tax changes on carried interest that would have hit private-equity investors. This is an improvement.

In exchange, however, she and Senate Democrats are imposing another bad idea—a 1% tax on the market value of shares that companies buy back from their shareholders.

Companies use buybacks to return cash to shareholders for which they don’t have a better use. Shareholders who sell shares back to the company can invest the proceeds elsewhere. For the economy overall, capital flows from companies that don’t need it to companies that do.

— “Trading One Bad Tax for Another,” by the Editorial Board, Wall Street JournalAugust 6, 2022.

For the Wall Street Journal editors, who put the interests of financial elites first, Senator Kyrsten Sinema “giveth” and then “taketh away.” For the rest of us, Sinema does a whole lot more taking away than she does giving. That’s evident once again with the Inflation Reduction Act of 2022 that the 50 Democrats in the Senate passed through the reconciliation process in early August. When Sinema insisted that to get her vote, the provision narrowing the carried interest loophole—a tax giveaway for private equity fund managers—be dropped from the bill, the editors couldn’t have been happier.

To replace the lost tax revenues, however, Sinema gave her okay to a 1% excise tax on corporate stock purchases from their shareholders—another “bad” tax idea, according to the editors.

But Sinema, along with Democrat Senator Joe Manchin, not to mention the opposition of all Republican senators, did far more to make sure the wealthy would not have to pay their fair share of taxes than just the horse trading needed to get Sinema to vote for this Senate bill. Proposals to increase the corporate income tax, taxes on capital gains, and the top personal income tax rate had all bit the dust earlier in the negotiations.

With that said, let’s look at why an excise tax on stock buybacks and closing the carried interest loophole are good for the economy and would help make the rich pay their fair share of taxes.

Carrying Water for Private Fund Managers

The carried interest loophole dramatically reduces how much the well-heeled executives of private equity firms pay in income taxes. Their job is to manage pooled investment funds from a range of sources, including pension funds, endowments, sovereign wealth funds, and wealthy individuals. Fund managers are paid a fixed fee, usually 1% or 2% of the size of their fund, and a share of any profits made by the fund, typically about 20%; the latter payment is called “carried interest.” Their fixed fee is taxed at the same rate as other income—in their case, at the top income tax rate of 37%. But carried interest, the chief source of their wealth, is taxed as capital gains (profits on investment) at a preferential 20% income tax rate. In 2021 the named executives at just five of the biggest private equity firms received a total of close to $760 million in carried interest compensation, as reported by the Wall Street Journal. Had those fees been taxed at the 37% rate instead of the 20% rate, the carried interest loophole saved them about $129 million in tax payments.

Before Sinema’s intervention, the Senate bill would have narrowed the carried interest loophole by applying it only to fees from capital gains held five or more years, instead of three or more years. That provision would have raised $14 billion in tax revenues for the government in the next decade. A 2021 Senate proposal to close the carried interest loophole altogether would have raised $63 billion over a decade.

The argument for the preferential treatment of capital gains is that it rewards those who undertake the risk of investing their money. It is a dubious argument in the case of capital gains. But equity fund managers are not investing their own money, but other people’s money. Why, then, should their compensation be treated like a capital gain? All sorts of contingent labor income—from performance bonuses to lawyer contingency fees to royalties—gets taxed at the top income tax rate. Even a huge bonus, say $1.5 million, would be considered as supplemental wages by the Internal Revenue Service, and would be taxed at the top income tax rate, which is 37%. This leaves little reason to continue the carried interest tax loophole other than to make the already rich even richer. That was not enough even for Gregory Mankiw, the former chair of the Council of Economic Advisors under President George W. Bush. I have argued that “from an economic perspective, carried interest should be taxed the same as other compensation for services.”

Buyback Better?

Like closing the carried interest loophole, an excise tax on stock buybacks was part of the original Build Better Back framework. While not targeted directly at the barons of Wall Street, the tax will help make the well-to-do pay their fair share of taxes, and it will have a salutary effect on the economy, despite the editors’ protests. Here’s why. Just like the tax you pay when you buy gasoline, corporations will pay a 1% tax on the market value of the stock they repurchase. More precisely, the tax is levied on the net value of stock repurchases—the value of the shares the corporation buys back, minus the value of any newly issued stock.

Corporations have been buying back their stock in droves. The companies included in the Standard & Poor’s 500 (S&P 500) bought back $6.2 trillion of their shares in the last decade. While the excise tax is 1% (just one half of the 2% rate initially included in the Build Back Better framework), it nonetheless will raise $73 billion in tax revenues over the next decade. For the editors, stock buybacks are something to celebrate. As they put it, stock buybacks commission “capital flows from companies that don’t need it to companies that do.” But stock buybacks are far more about not investing than promoting efficient investment. To begin with, what is holding back investment is too few profitable investment projects, not a shortage of profits to invest. After-tax corporate profits relative to Gross Domestic Product (GDP) have continued to hover around record-setting levels and are considerably higher than they were in the last five decades.

In addition, corporations are flush with cash. Much of the reason for their surfeit of cash is the Trump administration’s tax cut of 2017, which lowered the tax rate on corporate profits from 35% to 21%. Corporations saved $94 billion in tax payments in 2018. Economist Emanuel Kopp and his fellow International Monetary Fund researchers found that Fortune 500 companies spent just 20% of their increased revenue from the tax cut on capital expenditures and research and development. Stock buybacks, however, hit a record high in 2018 and account for the largest share of cash spending of companies in the S&P 500.

The editors did get one thing right: Corporations are not investing and are instead buying back shares because they claim to have nothing better to do with their cash.

What’s more, today, few stock purchases do anything at all to transfer money from savers to corporations who might invest those savings. Rather, more and more stock purchases are resales—exchanges where money goes from one holder of the stock to another, not to the corporation who the Wall Street Journal editors say will invest the money.

Economists Robert Pollin, James Heintz, and Thomas Herndon of the Political Economy Research Institute have carefully tracked this trend. They found that in the period from 1970 to 1979, about $1.20 in stocks were traded on the exchanges for every dollar of new productive investments by nonfinancial corporations. By the period from 1998 to 2014, however, roughly $22 in stocks on average were traded on the US exchanges for every dollar a corporation spent on purchasing new equipment and plants. The ratio is even higher today. In 2021, $34 in stocks were traded for every dollar of fixed investment.

If just $1 out of every $34 that shareholders use to purchase new stock gets invested by corporations, it is hard to imagine how Biden’s 1% excise tax on corporate stock buybacks would have a significant negative effect on productive investment, as the Wall Street Journal editors claim. Instead, it should help to reduce some of the speculation that dwarfs investment on today’s stock market. That is a good thing.

So, too, is discouraging stock buybacks. After all, if stock buybacks spend cash corporations are not investing, and there is little prospect that cash will be invested elsewhere, what do stock buybacks accomplish? “The simple truth,” as economist William Lazonick puts it, is that stock buybacks reduce the number of outstanding shares and drive up stock prices and earnings per share of stock, directly benefiting top executives. In a recent study, Lazonick and economist Lenore Palladino report that stock-based instruments on average accounted for just over four-fifths of the pay of the 500 highest paid US executives in 2019.

Please, Yet More “Bad” Tax Ideas

In today’s economy, where the richest 400 taxpayers now pay a smaller share of their income in taxes than the bottom half of taxpayers do on average, and CEO compensation is more than 350 times that of the typical worker, what we need is not one, or even two, of the editors’ “bad” tax ideas but many more. A 1% excise tax on stock buybacks helps, but a 2% excise tax would have been better. Eliminating, not just narrowing, the carried interest loophole is imperative. A 15% minimum tax on corporate profits is a good start, but we also need to increase taxes on corporate profits. And we must tax the wealth of the superrich as it is accumulated—take it back as they take it from all of us.

is a professor of economics at Wheaton College and a member of the Dollars & Sense collective.

Editorial Board, “The Houdinis of Carried Interest,” Wall Street Journal, August 7, 2022 (wsj.com); Robert Pollin, James Heintz, and Thomas Herndon, “The Revenue Potential of a Financial Transaction Tax for US Financial Markets,” International Review of Applied Economics, July 30, 2018; Arthur MacEwan, “Stock Buybacks: Any Positive Outcome?” Dollars & Sense, Nov./Dec. 2016; William Lazonick, “Profits without Prosperity,” Harvard Business Review, Sept. 2014; Leonore Palladino and William Lazonick, “Regulating Stock Buybacks: The $6.3 Trillion Question,” Roosevelt Institute Working Paper, May 2021; Aviva Avon-Dine, “An Analysis of the ‘Carried Interest’ Controversy,” Center on Budget and Policy Priorities, August 1, 2017 (cbpp.org); Emanuel Kopp, Daniel Leigh, Susanna Mursula, and Suchanan Tambunlertchai, “US Investment Since the Tax Cuts and Jobs Act of 2017,” IMF Working Paper, May 2019 (imf.org); Emily Cochrane, “Here’s How Democrats’ Big Domestic Agenda Bill Has Shrunk,” New York Times, August 7, 2022 (nytimes.com); Brian Slodysko, “Sinema took Wall Street money while killing tax on investors,” Associated Press, August 13, 2022 (apnews.com); Congressional Research Service, “Taxation of Carried Interest,” August 4, 2022 (crsreports.congress.gov); Miriam Gottfried, “Carried-Interest Change Would Hit Top Wall Street Brass, but Could Be Hard to Make Stick,” Wall Street Journal, July 29, 2022; Jane Gravelle, “An Excise Tax on Stock Repurchases and Tax Advantage of Buybacks over Dividends,” InFocus, August 10, 2022 (crsreports.congress.gov); Theo Francis, “Stock-Buybacks Tax Heps Offset Cost of Changes to Inflation Reduction Act,” Wall Street JournalAugust 10, 2022 (wsj.com).

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