There's been a furor recently over companies taking their spare cash and using it to buy back shares of their stock. Many politicians on both sides of the aisle see stock buybacks as a betrayal of the implicit deal that the federal government made with businesses when tax reform reduced the corporate tax rate from 35% to 21%, and use of share repurchases has become even more widespread in the year since those lower tax rates took effect.

Sen. Marco Rubio, R-Fla., recently joined the chorus of critics of stock buybacks, arguing that because they simply return money to shareholders rather than making internal investment in capital projects within the company, they don't represent as productive a use of available assets. Yet his argument to end what he sees as a tax advantage of buybacks over regular dividends makes fundamental mistakes about what buybacks really mean -- and might introduce a tax on shareholders that would be almost impossible to implement fairly.

Alarm clock with piles of coins and letter magnets spelling Tax on a wood table.

Image source: Getty Images.

The ambiguity of what Rubio's suggesting

In his recent plan, Rubio says the following:

Cash spent on share repurchases is not cash spent on capital investment. ... Share repurchases are tax-advantaged over dividends, due to the structure of capital gains taxes. Tax policy changes to end this preference might, on their own, increase investment by shifting shareholder appetite for capital return. To the extent structural incentives remain for capital return, an increased tax rate on repurchases might raise revenue to finance other incentives for capital investment like full expensing.

The plan's reference to what it calls a preference involves how the two methods of capital return get taxed. With dividends, every shareholder gets taxed on the cash received. With stock buybacks, only those shareholders who elect to sell their shares back to the company recognize a taxable event, and they're only taxed on the difference between what they received from the company and what they initially paid for the stock. Often, the actual tax rates are the same, as qualified dividend income gets taxed at the same rate as long-term capital gains.

However, the current version of the Rubio plan doesn't go into detail about exactly how policymakers might equalize the tax treatment of these two capital-return methods. Moreover, the suggestion that the two transactions should be treated the same ignores the fact that their impact on shareholders is much different.

Why dividends aren't the same as buybacks

There are two reasons why equal tax treatment of dividends and buybacks wouldn't really make sense. First, dividends and share buybacks look nothing alike from a shareholder perspective. Dividends give every shareholder a cash payment, while buybacks have no impact on most shareholders who simply hang onto their shares. Taxing shareholders who choose not to take advantage of an opportunity to sell their shares back to the company is inconsistent with tax policy on owning stock.

Many argue that buybacks increase the value of a company without forcing investors to recognize that increase as income. However, that's not always the case. It's true that buybacks reduce the number of shares outstanding, but they also reduce the amount of assets that the company owns. Indeed, when a company pays too much on a stock buyback, it can reduce the value of the remaining shares.

Warren Buffett put it best in his 2012 letter to shareholders of Berkshire Hathaway:

Repurchases [are] sensible for a company when its shares sell at a meaningful discount to conservatively calculated intrinsic value. Indeed, disciplined repurchases are the surest way to use funds intelligently: It's hard to go wrong when you're buying dollar bills for $0.80 or less. ... But never forget: In repurchase decisions, price is all-important. Value is destroyed when purchases are made above intrinsic value.

An unfair bureaucratic nightmare

The other reason why the Rubio proposal is ill advised has to do with implementing the proposal. Presumably, in order to equalize the tax treatment of a buyback, Rubio would treat the amount of the buyback as a deemed dividend made pro rata to all shareholders -- regardless of whether they participated in the buyback.

That treatment would be eerily similar to another much-criticized tax situation involving mutual funds. Traditional mutual funds are required to make capital gains distributions to shareholders that carry out the taxable gains that the funds generate when they sell the stocks they own. Shareholders are forced to include those distributions as taxable income, even though the bulk of them take the distributions and reinvest them into new shares of the mutual fund.

At least with capital gains distributions, shareholders have the option to take cash if they choose. With a stock buyback, there'd be no cash involved for anyone who didn't sell shares. Moreover, with the decision solely up to the company whether to do a buyback, ordinary investors couldn't do anything to stop this taxable event.

Demand smart tax policy

It's easy for lawmakers to make statements that reflect popular opinion about key issues, and there's no question that the use of corporate capital is controversial right now. However, lawmakers also have a duty to make well-reasoned proposals to implement solutions to the issues they identify. The Rubio proposal doesn't yet do this, and it'll take a lot of extra work before a final version could adequately address concerns about buybacks without introducing inequities of its own.