Think Debt-Funded Stock-Buybacks are Pernicious? Here’s Why You’re Right

I’ve ranted about this phenomenon for a long time:

Do Businesses Borrow to Invest in Productive Assets?

Quoting JW Mason: “the marginal dollar borrowed by a nonfinancial business in this period was simply handed on to shareholders, without funding any productive expenditure at all.”

We Need to Spur Business Investment. Yeah, Right.

Quoting Floyd Norris: “From the fourth quarter of 2004 through the third quarter of 2008, the companies in the S.& P. 500 — generally the largest companies in the country — reported net earnings of $2.4 trillion. They paid $900 billion in dividends, but they also repurchased $1.7 trillion in shares. As a group, shareholders were paid about $200 billion more than their companies earned.”

It just seems wrong. But I haven’t been able to enunciate, in economic terms, exactly why it’s wrong

I find that William Lazonick has done so for me:

Profits Without Prosperity – Harvard Business Review

Brief summary, in my words:

The “safe-harbor” stock-buyback provisions of Rule 10b-18 of the Securities Exchange Act, passed in 1982, gave C-suite executives carte blanche to extract rents for their own benefit via stock-price manipulation.

This of course gave them the incentive to do so. And they have done so. The rule turned real business managers who “think like owners” into financial prestidigitators who manage their businesses for their own extractive enrichment, not for the good of the business.

Read the whole thing.

One thing that Lazonick doesn’t discuss (but Mason and Norris do) that seems huge to me: interest payments are tax-deductible for corporations. Dividend payments aren’t. This gives them yet another huge incentive to fund their activities through debt rather than equity issuance — and to borrow money for stock buybacks.

Economists almost universally bemoan the mortgage-interest deduction on efficiency grounds (and equality grounds). I really wonder why they don’t vilify all interest deductions, (especially) including the corporate interest deduction. Given the destructive effect on prosperity of the debt-fueled stock-buyback dynamic, it’s arguably even more pernicious.

We should make Rule 10b-18 much more restrictive or repeal it entirely, and we should remove all interest deductions from the tax code.

Cross-posted at Asymptosis.