How the Government Incentivizes Corporate Greed

Stock buybacks used to be viewed as intolerable corruption, but thanks to a 1982 law signed by Ronald Reagan, they are legal, and the Overton Window has shifted to accommodate their supposed normality. Corporate greed generally is the centerpiece of attention whenever this subject arises, and it certainly is a big part of it in our late-stage capitalist dystopia, but standard government policy is a serious motivating factor influencing this practice.

Stock buybacks are where executives purchase shares off the market (or directly from their shareholders), and it boosts the company’s earnings per share and likely its stock price too thanks to the laws of supply and demand. Joe Biden decried their practice while announcing a new 1% tax on them in his 2023 State of the Union, and this year he wants to quadruple that tax as it has not halted the practice at all.

This is classic modern liberalism, trying to ameliorate a symptom rather than addressing the root cause of the problem.

This is another in my series of How I Got Radicalized in Finance Grad School, with the first walking you through how neoliberalism is a lie proven by the math at the base of capitalism. Modern public company executives may be historically greedy, by they also have a legal fiduciary duty to maximize profitability, and one key quirk of the corporate tax code incentivizes them to make stock buybacks.

Companies are financed in one of three ways: all debt, all equity, or a mix of the two. The rewards for equity shareholders are dividends, and debtholders receive interest payments. The United States government has decided that interest payments are tax deductible, but dividends are not. This incentivizes companies to replace equity with debt because deducting the interest payments they make on their debt can make companies more profitable.

Yes, you read that right, debt can be profitable. Welcome to America!

Buying back stock is one way to tilt a company’s debt to equity ratio towards debt. In 2013, Apple borrowed $17 billion to save $9.2 billion in taxes, and provided the most high-profile example to that point of this fundamental dynamic that influences every single balance sheet and income statement. Per Reuters (emphasis mine):

With the $10 billion share repurchase announcement made last year, the entire $60 billion stock buyback is the largest share repurchase plan in history, and will take until 2015. The problem is that most of Apple’s cash — some $100 billion U.S. — is overseas. And bringing that loot home would result in taxation at a 35 percent rate.

$35 billion extra in government coffers probably gives Washington hot flashes and sweaty palms, but it keeps Apple accountants awake at night. So the company is borrowing the cash it needs by issuing a record $17 billion bond offering with interest yields slightly higher than U.S. treasuries.

Borrowing money, paradoxically, is saving Apple money.

In addition, Bloomberg notes, interest Apple pays on the $17 billion debt financing will be tax-deductible, saving an additional $100 million a year.

If that same proportion of debt had been housed in equity instead, and Apple made dividend payments to equity holders on it, they would not have saved an additional $100 million a year. This is how the government incentivizes companies to take on debt in the name of profitability.

Additionally, due to how the market interprets dividends (if a company cuts its dividend, its stock price will fall in anticipation of lower profitability), there is less incentive for companies to use that method to return cash to their shareholders. Thanks to both government and market incentives, it is more practical for most companies to return cash to their shareholders by just repurchasing their stock, boosting executive compensation in the process by increasing the value of their shares.

The bankrupt Bed Bath & Beyond is a cautionary tale of the profligate spending this policy incentivizes. Executives spent $11.8 billion on stock buybacks and took $2 billion out in loans to service this agenda in 2014. Now that the company has filed for Chapter 11 bankruptcy, it is certain that those debt-holders will never see anything close to that return on the loans they made. This neat little trick worked for Bed Bath & Beyond up until it very much did not, and the executives who ran that company into the ground had no other choice than to file for bankruptcy once the market turned against them.

Stock buybacks are increasing in part because lots of companies like Apple are sitting on larger and larger piles of cash. There is a clear correlation between having more cash than a company knows what to do with and using it to try to boost share prices. Between Q1 2009 and Q2 2022, the tech industry spent $2.1 trillion on stock buybacks, with financials coming in at the second-most at $1.3 trillion. Whether these publicly traded companies are properly investing in their own businesses is the business of their boards and shareholders, but it is clear that repurchasing stock is an important strategy of these cash-laden industries.

Ascertaining the degree to which this dynamic influences stock buybacks is difficult given the inability to truly know the motivations of public company executives, but a 2002 study that took place before stock buybacks became far more common found that “firms that announce stock buybacks have lower debt-equity ratios than firms that do not announce buybacks.” This suggests that repurchasing stock is historically a motivating factor in tilting a debt-to-equity ratio more towards debt.

Leveraged buyouts are another hellish capitalist reality boosted by interest expense being tax deductible. Hedge funds have famously destroyed well-run companies like Toys ‘R’ Us through the aid of this tool.

In 2005, Toys ‘R’ Us was a public company with $1.86 billion in debt before Mitt Romney’s Bain Capital and other hedge funds KKR and Vornado bought it. They took it private, then increased its debt to $5 billion. By 2007, Bloomberg reported that interest expense comprised a staggering 97% of the company’s operating profits. An article in The Atlantic in 2018 detailed how this corporate horror story unfolded, and the future lessons that arose from it.

An analysis by the firm FTI Consulting found that two-thirds of the retailers that filed for Chapter 11 in 2016 and 2017 were backed by private equity.

“Had these companies remained publicly owned,” [Thomas] Paulson said, “they would have had a much higher probability of being able to adapt, to invest, and to withstand” the ups and downs of the economy.

This was a great deal for the hedge funds, as they took out debt the company had to pay back, not themselves, and they got to falsely claim they were improving the business when what they were really doing was dramatically reducing its flexibility by tying its operating revenue to making (tax deductible!) interest payments. Bain Capital claimed in 2005 that one feature of this strategy is to make the company more profitable, but the FTI Consulting analysis casts serious doubt on that assertion.

As companies like Toys ‘R’ Us and Bed Bath & Beyond have demonstrated, just because you can increase profitability by taking on more debt and writing off the interest expense does not mean you are actually running a profitable company. This is one of the great examples of how financialization has helped to destroy our economy, as the Bain Capitals of the world care far more about what the balance sheet currently looks like than what the future of the business does.

Using a leveraged buyout to take over a company and “make it profitable” in practice generally means loading it with a ton of debt, stripping it for parts, then making the financial statements look pretty with the goal of selling it to a bigger sucker in a few years.

If the government did not rule that interest payments are tax deductible, then the Mitt Romneys of the world would have less flexibility in their hostile debt-laden takeovers. This policy has less of an obvious causal effect on share buybacks, but the incentive structure it creates around them is crystal clear, as proven by gigantic companies like Apple. Joe Biden can back all the legislation he wants to try to limit stock buybacks, but we have more than a decade’s worth of data demonstrating that the foundational government policy of making interest expense tax deductible incentivizes them.