The False Choice Between Investment and Buybacks

September 14, 2018

One of the most persistent criticisms of the Tax Cuts and Jobs Act (TCJA) has involved the issue of stock buybacks. Instead of encouraging companies to reward their employees through increases in wages or investment, so the argument goes, the reduced corporate income tax rate has enabled them to enrich the wealthiest by buying back company stock.

Regarding a recent report on stock buybacks, Jared Bernstein, former economic adviser to Vice President Joe Biden, said: “This confirms precisely what many of us expected from the tax cut, despite the fact that the cut’s proponents argued otherwise. I argued that we’d see a surge in buybacks before we saw a surge in investment. That’s been demonstrably the case.”

Criticism of this sort rests on the assumption that there is a choice between investment and buybacks: Either companies can put revenue into investments that will create jobs, support employees, and grow the economy, or they can buy back stock and reward wealthy shareholders. However, the choice is a false dichotomy that fails to acknowledge the causes of long-term economic growth.

When any firm is considering performing a certain action (including whether to make an investment), it calculates the costs of the action and compares them to the benefits. If the benefits outweigh the costs (one of which is taxes), the firm will go ahead with the decision; if they don’t, it won’t.

Consider this scenario: A company made investments prior to the TCJA and the reduction in the corporate income tax rate. The company decided to invest in a project, such as a new factory, because it had determined that the benefits of doing so would outweigh the costs, assuming a given tax rate. Now, with a lower tax rate and therefore lower costs, the company is making higher-than-expected profits on that investment, resulting in excess cash.

Now, the company, post-TCJA, is deciding what its next move should be. The choice isn’t between buybacks and investment. The company will again review the costs and benefits of making any additional investments. The new, lower tax means that the cost of capital has fallen, and some investments that previously would have been too expensive have now become feasible.

But it’s also possible that the firm will still have residual cash flow left over after all profitable investments have already been made. At this point the firm would now engage in stock buybacks to ensure its excess cash is used well.

It will be years before we can fully separate the noise from the signal regarding the TCJA. However, we can already tell from what we know about company decision-making that the choice firms are facing and will face in the future won’t be between buybacks and investment.

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