Stock options, the buyback boondoggle and the crisis of capitalism
As if there weren’t already enough reasons to eliminate the egregious stock option tax loophole, a column by Eric Reguly in this month’s Report on Business magazine highlights yet another. This reason helps to explain why we had such a booming stock market up to 2008, but little growth in real investment and productivity.
First of all, the stock option deduction, which allows those recipients of stock options to only pay half the statutory rate of income tax on their gains is:
Expensive, costing Canada’s federal government an average of almost $1 billion a year in foregone tax revenues annually during the past five year, according to Finance Canada’s tax expenditure accounts.
Unfair, with the benefits going overwhelming to those with the highest incomes, including CEOs, as Hugh Mackenzie has outlined in his annual CEO pay  report for the CCPA.  For example as I showed a few years ago, this tax loophole saved Robert Gratton, former CEO of Power Corp over $24 million in federal income taxes, just on one year’s income.  This is a major reason why some of the highest paid people in our society pay tax at a lower rate than ordinary workers.
Distortionary and destabilizing, creating the misaligned incentives and pay structures that reward short-term risk taking that Bank of Canada governor Mark Carney identified as one of the key reasons for turbulence in the financial markets in a speech he gave two years ago.
Bu there’s an even more devastating reason why the tax loophole for stock options should be eliminated: it has been very damaging for the economy.
Research by William Lazonick, director of the Centre for Industrial Competitiveness at the University of Massachussets, shows that stock buybacks–using a company’s funds to buyback its own shares–has swallowed up an enormous amount of the income of major US companies.  Canadian companies have also put increasing amounts of their income into stock buybacks and not into more productive investments, as I outlined a few years ago.
The stock buybacks have resulted in pretty blatant stock price manipulation, boosting stock price value for these companies, and paying off very handsomely for those who hold shares, which includes most CEOs and senior executives, especially since they only pay half the rate of tax on these gains.  It’s been great for shareholders and other employees who also own shares, at least in the short-term.
The problem is that in the long-term it has bled the economy of real investment in the economy. As Reguly writes:
Every dollar spent on buybacks means one less dollar spent elsewhere-on R&D, on training, on equipment, on creating employment, on innovation. Ultimately, competitiveness and economic growth suffer.
This issue is related to the broader discussion we’ve recently had on this blog about the ineffectiveness of corporate tax cuts.
Lazonick ties this to a broader crisis of US capitalism’s “New Economy business model”, says we should ban stock buybacks where they are used to manipulate prices, and writes that the:
The government also needs to enact legislation that drastically reins in top executive pay, which means placing restrictions on stock-based remuneration, especially stock options.
We will soon see in the federal Throne Speech and budget what Canada’s federal government has planned to revitalize Canada’s economy coming out of this recession.  But if it is just more faith in the same old simplistic laissez-faire Advantage Canada framework without fixing any of these problems, it will have very little success.
I thought stock buybacks where an alternative to giving shareholders dividends because of the lower tax rates you point out.
If you where to ban them, why wouldn’t companies start giving out dividends again rather then invest in R&D and innovation?
The point is that the buybacks pump up the stock value and thereby the value of stock options that are held by the executives that make these decisions. This has been done because of that self-interest instead of more productive investments. Paying dividends would have much less of an impact in goosing up the share price. And he doesn’t call for banning them entirely.
Good points Toby. As I stated previously, you will not see a reality show soon on how CEO’s and the boys get paid.
It would be a great full hour show reality show starring some of Canada’s TOP CEO’s (and American as I am sure their taxation situation is similar). I am thinking, LOST- BAY STREET EDITION would be a great name. In the show the audience would pretend they are CEO’s and we would have a hand ful of real CEO’s. And we would hang out with them.
A special 2 hour episode could be made for tax time and we could sit with their tax lawyers and accountants. Of course we would have a running ticker on the screen with the annual income, taxes paid, shares owned, and share price of all the companies they have influence on. Course that might fill the entire screen so we might have to innovate on presenting the corporate influence graph.
Do you think the CBC might be interested? We could put it on right after Dragon’s Den!
I wonder what us peasants, especially in Greece might have to say about that.
Just after writing the above comment I read that a bunch of high profile comedians kind of stole my thunder!
See this it is a hoot
http://www.theglobeandmail.com/news/arts/snl-presidents-gather-for-video-summit/article1488335/
In the US, the SEC granted issuers safe harbor from charges of manipulation by Rule 10b-18 of 1982. Since then, buybacks have been the major force driving equity prices upwards as shown in Federal Reserve flow of funds accounts. The amount involved is US$5.7 trillion in 2008 dollars. The practice defrauds long-term shareholders because money that belongs to all shareholders goes to only a few. See the above website for many articles that discuss this topic from every angle.
Every dollar spent on stock buybacks is a dollar not spent on investment? Is the same true for dividends, salaries, and wages?
Nick:
I don’t know if you meant that as a serious question or as something purely rhetorical.
As I expect you may know, salaries and wages are usually not considered discretionary expenditures. Dividends are paid out of net earnings, but most companies that still pay them like to keep them at least stable, if not gradually rising if they are profitable.
Income that is available after these and other expenses can be used for more discretionary purposes, such as increased investment in plant, M&E, R&D, and other forms of expansion –or else they can be used for financial investments, paying down debt or share buybacks.
The point here is that share buybacks have used to manipulate stock prices and those making these decisions have profited handsomely, aided and abetted by preferential tax provisions.
Other shareholders have also benefitted in the short-term, but at the expense of investment and longer-term growth.
It may be that all these companies felt that there were no other suitable productive investment opportunities to put their profits into. I prefer to think that’s not the case, otherwise there’s not much hope for the future of our economic system! Or perhaps profit rates are too high and corporate taxes should be raised with the revenues steered into public investments.
One could draw a simple conclusion from this evidence that is actually quite moderate; one that I would expect advocates of better-functioning markets should enthusiastically support: preferential tax rates on stock options have distorted investment decisions. If they were fixed, our economy would function more efficiently and grow faster.
I find it odd and somewhat concerning that it is often those on the left who are the strongest advocates for better functioning financial markets.
dividends and stock buy backs are both methods of returning profits to shareholders. Stock buy backs are preferred these days because of the tax advantages. If those advantages where removed, which is something I would probably support, why wouldn’t companies go back to paying dividends, resulting in no increase in investment?
Toby:
“Nick: I don’t know if you meant that as a serious question or as something purely rhetorical.”
A bit of both, really. I should have been more explicit. But you interpreted my question in the right spirit. I think that your response, and Darwin’s response to you, push the debate forward. The key questions, in my mind, are:
1. Is the firm paying out more than it needs to (in, say, executive compensation, or whatever) to attract the resources it needs?
2. What would happen to the money otherwise?