Tuesday, December 26, 2017

The Buyback Fallacy

Many commenters on the tax bill repeat the worry that companies will just use tax savings to pay dividends or buy back shares rather than make new investments.

Savannah Guthrie, interviewing Paul Ryan on the Today Show, thought she had a real gotcha with
"What they [CEOS] are planning to do is stock buybacks, to line the pockets of shareholders."
(She then moved on to a question most guaranteed to produce retweets of partisan admirers, and least likely to produce an interesting answer,
"I'll ask you plainly, are you living in a fantasy world?"
NBC then wonders that it is charged with partisan bias.)

Peggy Noonan, in an otherwise thoughtful column, echoed the same worry:
"Big corporations can take the gift of the tax cut ... and do superficial, pleasing public relations sort of things, while really focusing on buying back stock and upping shareholder profits."
(Just how taking less of your money is a "gift" is a question for another day.)

So, having established that this is a bipartisan worry, let's put the fallacy to bed. It is the fallacy of composition, that actions of one company mirror actions of the economy as a whole. It is the fallacy of "paper investments" vs. "real investments." That distinction can apply to a company, but not to the whole economy.

What corporate cash is not. 
No, companies do not sit on vast swimming pools of gold coins, like Scrooge McDuck. One company's "cash" is a short term loan to another company, which the latter uses it to make real investments. Every asset (paper) is also a liability, backed by an investment. The charge fails to track the money.  One of the few things economists know how to do is always to ask, "OK, and then what do they do with the money?" Money is a veil, and real decisions are (to first order) independent of financial decisions. (I use italics to suggest some ways to remember these basic economic ideas.)

Suppose company 1 gets a tax cut, doesn't really know what to do with the money -- on top of all the extra cash the company may already have -- as it doesn't have very good investment projects. It  sends the money to shareholders. Well, what do shareholders do with it? (Hint: track the money.) They most likely roll the money in to other investments. They find company 2 that does need the money for investment, and send it to that company. In the end, they only consume it if nobody has any good investment ideas.

If company 1 doesn't have any good investment ideas, even after the tax cut, and company 2 does have some good investment ideas, made better after the tax cut, the economy needs to get money from company 1 to company 2. Company 1 could buy company 2; company 1 could invest in company 2 by buying its stock or buying its debt (all that "cash" you hear about); company 1 could return money to shareholders, and the shareholders could invest in company 2. They're all the same, to economics. Of all the ways to do this, actually, the last might well be the most efficient. Shareholders might have better ideas about good investments than managers of a company that doesn't have any good investment ideas.

The larger economic point: In the end, investment in the whole economy has nothing to do with the financial decisions of individual companies. Investment will increase if the marginal, after-tax, return to investment increases. Lowering the corporate tax rate operates on that marginal incentive to new investments. It does not operate by "giving companies cash" which they may use, individually, to buy new forklifts, or to send to investors. Thinking about the cash, and not the marginal incentive, is a central mistake. (It's a mistake endemic to Keynesian economics, but the case here is supply-side, incentive oriented.)

The point is the same as one I made in an earlier post, not to expect "repatriation" of corporate profits to make much difference to investment. Apple Ireland could already put money in a bank that lends to a US bank that lends to Apple US, if that money's best use was in the US. The marginal profitability of investment is all that matters.

Now, let me also quickly grant that there are second-order effects and frictions. Perhaps due to "agency costs," internally generated cash is a cheaper source of investment funds than cash obtained by issuing stock or borrowing. In that case, financing decisions do matter. Tracking down this sort of thing is what makes economics fun. But good economic analysis always starts with the relevant budget constraint or neutrality theorem, and then adds the frictions. Neither Ms. Guthrie nor Ms. Noonan had such a second order financing friction in mind.

Do not take this post as criticism of either author. They just happened to repeat the charge, which is floating around as part of the larger talking-point battle surrounding the tax cuts. Ms. Guthrie is an anchor trying to lob nasty questions, and Speaker Ryan could have answered this way. He chose a better answer in fact, recognizing that like "fantasy world" it was not a serious question. Ms. Noonan is a political commentator, and this minor fallacy does not detract from her interesting, larger, political point: Forget that returning cash to investors who quietly put it in better companies is economically efficient. If large companies are seen to just hand out presents to investors rather than to invest the funds internally, the political optics of the tax cut will be bad for its defenders. Sometimes paying attention to fallacies can be good P. R. It is, however, the job of economists as public intellectuals (subject of an upcoming post) to patiently point out this sort of thing, so maybe someday voters will not confuse P. R. stunts with progress.


  1. If the Republicans had been more clear on what channels they saw as resulting in increased investment perhaps they would have elicited better questions.

    Watching the debate with half an eye, it seemed to me that the Republicans put out multiple rationales: (1) employees carry the burden of corporate taxes and this cut will lead to the typical employee getting a $4,000 pay increase; (2) the tax cut will attract foreign investment who will build factories in America and employ Americans; companies will invest the money they save or repatriate in new factories in America creating employment in America;

    Personally I believe the Republican Party does not know or care what the effects of the tax reform will be beyond making their major donors richer in the short term. As President Trump is reported to have said at his golf course to a group of his friends "You all just got a lot richer"

    Since I own some American equities in my retirement account, I suppose that I will personally be a little bit richer.

    1. You started off with "Republicans don't have a good rationale"...and ended with "and here's my opinion which is based on no rationale whatsoever". Yeah my guess is, no matter what the Republicans say they will elicit such questions and opinions. It's not as if this is the first time the Left has freaked out.

    2. Anonymous

      I would welcome a reference from you to an official explanation / model / analysis from the Republicans explaining how the corporate tax cut will impact the economy. If such an explanation does not exist, you could explain why there is no such official analysis.

  2. "The point is the same as one I made in an earlier post, not to expect "repatriation" of corporate profits to make much difference to investment. Apple Ireland could already put money in a bank that lends to a US bank that lends to Apple US, if that money's best use was in the US. The marginal profitability of investment is all that matters."

    Your overall point is well taken, but this specific example is not correct or at least very highly misleading. Internal Revenue Section 956 does not allow Apple to use, directly or indirectly, those non-repatriated funds to invest in "US property" without paying a large tax on those funds that would be deemed to be repatriated. An "investment in US property" includes not only investments in US plant and equipment, but also stock in US companies (including Apple stock in a buyback), etc. Important, as to why your example is wrong, is the fact that "back-to-back" arrangements to get around these prohibitions is also explicitly prohibited.

    Apple US can borrow from that US bank but only on the same terms it could borrow from any other bank in the US or elsewhere. (Thank you, Apple foreign subsidiary, for increasing liquidity with those funds deposited in that US bank and therfore lowering the marginal borrowing costs *for everyone*). Apple US cannot benefit from that deposit any more than one of its competitors (e.g., Samsung) could. See, specifically, the regulations under section 956 regarding "guarantees", "pledges", "conduit financing arrangements", etc., as well as the associated revenue rulings and so forth.


    The importance of not imposing a large tax cost on the repatriation of foreign profits is that Apple (and other similarly situated US multinationals) are much more free to allocate that capital to the uses it deems most efficient (including payments to shareholders, which is often a more effecient allocation of funds). Those offshore funds have *not* been less expensive to Apple than borrowed funds precisely because of these restrictions.

    Vivian Darkbloom

    1. Your point goes to second order "frictions". Apple can invest invest overseas profits in overseas accounts and earn a return. It can borrow in the US any pay interest to the lending bank. But for the frictions of paying the banks as financial intermediaries. Apple hasn't used the same funds, but (cost of frictions aside) it has effectively invested its foreign profits in the US without repatriating them and its bet worth stays the same.

    2. " Apple hasn't used the same funds, but (cost of frictions aside) it has effectively invested its foreign profits in the US without repatriating them and its bet worth stays the same."

      No, not really. Is there something prohibiting a US company without unrepatriated foreign profits from borrowing money from banks? Apple cannot use those funds, directly or indirectly, as a pledge or guarantee of a US bank loan to a US group company. Having those unrepatriated profits (and the large deferred tax liability that goes with it) likely marginally improves Apple's overall credit rating; however, as far as borrowing by US companies is concerned, that rating would be even higher if those prior profits were sitting in the US (and not subject to that future tax hit).

      But, yes, this is an example of one of those "frictions".


  3. John,

    "Many commenters on the tax bill repeat the worry that companies will just use tax savings to pay dividends or buy back shares rather than make new investments."

    The problem that both you and the rest of the commenting world fail to recognize is the effect of debt financed tax cuts - and no reasonable economist really believes that the tax cuts proposed will pay for themselves.

    Company A passes on debt financed tax cut to stockholder B who buys goods from supplier C who pays employee D who buys government bond - and then the incentives disappear. Employee D sits back and collects the interest paid by all tax payers while never lifting a finger.

    If Paul Ryan were actually serious about entitlement reform, reducing the federal debt would be at the top of his list - and yes, payments on the federal debt are a form of entitlement.

    1. I agree that taking the point of "tracking the money" to a higher level of abstraction requires looking at the how a debt financed tax cut changes the claims on resources that money represents. You have US bond buyer forgoing current consumption/investment so that tax cut recipients can consume/invest. This has be get reversed in later periods, which is why you see references to a current tax cut being they same as a future tax increase, all other things being equal.

      Thus, I think the macro effects of the tax bill are probably close to a wash. The benefits of the tax reform are at the micro level: less of an incentive to structure around a high corporate tax or to get deductions that have either gone away or become less important because of a larger standard deduction. (Even I however, can't see the benefit of the change to pass-though entity taxation!)

    2. DWAnderson,

      Close. Actually I was pointing out that whatever positive incentives to work are gained by lowering taxes are lost through interest paid on federal debt.

      Instead, it would make more sense for the federal government to sell tax breaks through the Treasury department. The positive incentive to work is retained (lower tax burden) without the negative incentive (interest on the debt).

      But try telling that to any banker (Mnuchin, Greenspan, etc.) and check out the looks of ridicule that you get.

  4. Dr. Cochrane, do you really buy into the libertarian Nozickian idea that all taxes are necessary evils? The quote, "(Just how taking less of your money is a "gift" is a question for another day.)" really does mystify me. How do you weigh the benefits of public spending and public goods (not to mention Pigouvian taxes) if you take all taxes to represent some inherent evil?

    1. His statement there has nothing to do with what you're attributing to it. His statement is self explanatory: not taking your money is not the same as gifting you money. It makes no moral judgement of evil or a necessary one. It's a statement of fact.

    2. Jackson,

      I presume you are referring to this:


      "Nozick’s first argument (1974, 169–71) can be summarized as follows: when you are forced to pay in taxes a percentage of what you earn from laboring, you are in effect forced to labor for someone else because the fruit of part of your labor is taken from you against your will and used for someone else’s purposes."

      Essentially, Nozick is arguing that taxation (of any kind) takes precious hours of labor away from one person and grants them to another.

      And I respond this way: We are each granted with a precious few number of years of life and labor. And yet, our monetary system is currently constructed such that it can expand and contract based upon the needs of society. Meaning that monetary expansion / contraction (and the taxation that goes with it) can happen independently of how long any one of us live or work.

      I could invent the Star Trek warp drive, borrow $100 billion at 3% to fund it's construction, and live off the proceeds of my invention as long as the returns on that invention exceed my financing + taxation costs.

      The important part of tax policy isn't the transfer of money from rich to poor, it is the cost that it adds to the production of goods.

      Nozick makes a shallow argument based on the supposition that all workers earn the same wage (they don't) in equating hours worked with monetary earnings.

    3. Anonymous: Thanks! I sometimes hold off in responding to comments to see if readers get the point. It's a good test of whether I'm writing clearly enough in the first place. You get an A+

  5. Suppose company 1 gets a tax cut, doesn't really know what to do with the money -- on top of all the extra cash the company may already have -- as it doesn't have very good investment projects. It sends the money to shareholders. Well, what do shareholders do with it? (Hint: track the money.) They most likely roll the money in to other investments. They find company 2 that does need the money for investment, and send it to that company. In the end, they only consume it if nobody has any good investment ideas.

    This smells as much as the package sent to Mnuchin. Very few people that receive dividends or special distributions from a company will make an investment that benefits anyone other than earlier investors. Unless the money goes to purchase new issue stock or bonds the underlying company does benefit.

    1. And...themselves of course ;) And where do these "benefits" that earlier investors and current investors make go? And then where does it go after that? And after that?

      Seems like you missed John's point by about 15 miles.

    2. If this is the same anonymous as the above comments, you just got two A+, and special commendation for reading comprehension.

  6. Just to add my comments, although I generally agree 100% with what you wrote. Share repurchasing can also be an "agency cost" to shareholders in the sense that often (sometimes) managers buy back stocks not because they have no use for the internal funds, but for agency reasons such as increasing stock prices or increasing control.

    Now as you said, even if we granted this, it makes no difference as the net effect is the same. At the aggregate level you get more efficient allocations. But the "Left" will still use it as an argument as to why it's bad (it's bad for them anytime someone makes money).

    And another reason why this is still a desirable outcome, at the firm level, is that less free cash is left in the firm for manages to use, sometimes, for inefficient purposes. Excessive free cash can be an agency cost in itself (and a big one). Is the "Left" advocating that companies horde money and engage in empire building? I thought they were against "big companies"? They really are full of contradictions. (not that it matters)

    Also, who are these mythical evil shareholders who profit from all of this? Might they be the 60% of Americans who own stocks? Might it be the employees of the firm who own pensions and 401ks and ESOPs? The "Left" is still stuck in this Marxian dystopian world of capitalists and proletariat. They haven't figured out yet who the capitalists are.

    I don't agree with you on repatriation (leaving aside the way it is argued for political expediency, or the mechanisms of accomplishing this). In a world of capital mobility, the argument of "it doesn't matter" doesn't hold out too well I think. You want capital inflow and if taxes were a barrier to this, then obviously its an easy barrier to remove. I guess we're in agreement there, other than in my opinion it does matter.

  7. "You want capital inflow"

    I expect that most of the offshore profits are already invested in US dollar assets (bonds, treasuries, bank deposits) so the repatriation of those off shore profits will not represent an "inflow" into the United States and will not have much impact on the dollar.

    That said, a genuine inflow of new foreign investment in response to tax reform would tend over the short and medium term to have the following effects: a higher dollar, higher imports and lower exports. The trade adjustment to that influx of foreign money would fall disproportionately on American manufacturing. The current administration may not be in favor of the temporary widening of the trade deficit that a foreign investment influx would cause.

  8. While I agree with the over all post & appreciate your thoughtfulness, I think it's open to the objection that most "reinvested" cash returned to investors via dividends or share buybacks, will simply be purchasing previously existing shares of public companies so therefore the new capital is not making it's way into the company accounts of undervalued businesses in need of that capital. I'm sure some will go to IPO's (which would mean the returned capital goes to another company in need), but I have to assume the vast majority of cash returned to investors would just increase the share value of previously issued shares & thereby not really benefiting the companies themselves.

  9. Great Article. The Trump/Republican Middle Class tax cuts have already had a huge impact. I don't know of anybody that was predicting all of these huge companies, a list that grows everyday, would return billions and billions of dollars to their Middle Class Workers in the form of $1000 bonuses, big pay increases, or both. Nobody could have guessed the Middle Class Tax Cuts would put money immediately into the pockets of the Middle Class, but it has. Month before the entire Middle Class sees a single $ from the tax cuts in the checks, but they will in Feb. 2018. This isn't a PR stunt, not with tens of billions flowing to the workers in these companies. These companies know that the Middle Class & Business Tax cuts are going to get the economy and jobs roaring next year. These very smart companies are working hard now to retain the employees they will need to expand, create jobs, and create more wealth starting now. The Middle Class/Business tax cuts were exactly the right medicine to lift the USA out of the misery of 8 years of Obama/Democrat misery that gave us the worst economic growth since the Great Depression. Trump by restoring confidence had already done a remarkable job, but now companies will have the stability and resources to finally expand now that the economy strangling regulation of Obama and the Democrats have been lifted. 2018 is going to be an amazing year. A year in which Trump and the Republican restore the Middle Class backbone of America that Democrats nearly destroyed. America is back!

    1. AT&T promptly turned around and announced layoffs:


    2. 600 jobs from a workforce of 200,000 employees. Try harder.

  10. What do you make of this comment on your post: http://newmonetarism.blogspot.com/2017/12/wheres-fallacy.html?

    1. Thanks for pointing it out. Answer in next post.

  11. I would have liked to see them lift the tax on dividends, so that companies had a greater incentive-and shareholders a very strong incentive to demand that they get their money if it's not used for investment inside the company. My practical experience is buybacks are a waste of cash, and only get executives out of option packages. They don't do much for long term holders of the stock. Understand the theoretical economics of buybacks are different, but it seems a poor use of corporate cash compared to dividends

  12. The point about buyback irrelevance and efficient reallocation is well taken, so no qualms with that. The same logic of total resource constraint can be taken further to dismantle the argument for this bill as a good policy. When tax cuts are not accompanied by reduction in spending (as is the case in point) the government will compete with private companies which need capital (type #2) to borrow the very same taxes it has given back. In the long run this would negate growth/investment effects of deficit financed tax cuts.

  13. One thing that's bothering me about this idea; if the tax cut ends up being primarily paid for by increased public debt, which is raised by selling US government bonds, then won't that absorb just as much investment as the tax cut adds to the pool of investment money? If the government issues a trillion dollars worth of US bonds, and at the same time gives a trillion dollars to people who will invest that money by buying stocks and bonds, then doesn't it basically cancel out, not counting the second-order effects and friction?

    1. Yosarian T, it depends on what the objective is.
      So billionaires get to spend a lot more money on (productive no doubt) investments. And the government ends up borrowing a lot of money (to be paid off by future ordinary folks).
      Perhaps those investments are just what we need to make the transition from our current fossil fuel burning economy to one that is powered by sunshine and such. If so then I am in favour of it. Perhaps those future ordinary folks who get to pay back the debt will also approve.
      But perhaps the objective is simply to enrich billionaires (and never mind ordinary folks) and perhaps it's all going as planned.
      We will see, for sure.

  14. Hi John,

    As some comments at the end point out, what is the net balance / consequences of the tax cut if government does not cut on spending ?
    Do you agree the Treasury will go after that same money through bond issuance and compete with the private sector on capturing the money ?
    But this is follow the money/cash right ? does not impact the marginal rate of return on investment that has de facto increased due to the lower taxation. So ?
    One last comment, in my view the most important long term impact of lowering corporate income tax in the US is to make the US more competitive when compared to other countries where corporate income tax is well below 34 or 35%.
    Do you agree with that ?
    In other words the marginal return on the dollar invested in the US increases and it should increase the attractiveness of investments in the US market.

    1. If the US does not "cut" (lower the rate of increase of) spending, and if GDP does not grow a lot faster than it has, then sooner or later the US will have to raise taxes. The major issue is entitlements, social security, other pensions, and health. There isn't enough money to pay for those by taxing "the rich" or "the big corporations." Any number of CBO projections make that clear. So, we'll either find a way to spend less on entitlements, or we'll use european taxes to pay for our, effectively, european benefits -- large increases in payroll taxes and a VAT--and reap european growth as a result -- slow but not disastrous. There will likely be chaos along the way as the US tries to avoid that budget constraint. So watch out for your wallet -- and for your incentives. The US may try big corporate or wealth taxes along the way, and may need a little debt crisis or inflation, though neither will solve the long run budget problem.


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