The Democrats have taken aim at the stock market's safety net by taxing buybacks - potentially creating another headwind for investors

Harry Robertson
Fri, August 5, 2022 

Senator Kyrsten Sinema (second from right) agreed to move forward with Joe Biden's bill on Thursday.Kevin Dietsch/Getty Images

The Democrats plan to put a 1% tax on share buybacks, as part of a deal to rescue Joe Biden's agenda.

Stock buybacks have supported the market in recent years, with companies spending huge amounts on their own shares.

Analysts said the tax could be a new headwind, but said companies would likely increase spending on dividends.

The Democrats have agreed to introduce a 1% tax on share buybacks as part of President Joe Biden's climate and tax bill, in a move analysts said could create another headwind for equity investors.

Arizona Senator Kyrsten Sinema, a moderate Democrat and former hold-out, agreed to move forward with what the party is calling the Inflation Reduction Act on Thursday night.

To gain her approval, Democrats dropped a provision that would have reduced tax breaks on the profits of hedge funds and private equity firms, known as "carried interest." Instead, they inserted a 1% excise tax on the controversial practice of stock buybacks, a person familiar with the matter told Insider.

Analysts said the new tax will not be welcomed by investors, just as they're grappling with rampant inflation and interest-rate hikes. They said buybacks have supported stock markets this year.

"Anything that touches buybacks is always a concern," Ben Laidler, global markets strategist at eToro, told Insider. "I think it's going to generate a lot of nervousness, just because buybacks are a big deal."

However, Laidler said the tax is likely to push companies to increase their dividends as they reduce buybacks. He said that may be preferable to many retail investors, who prefer a steady income stream.

A buyback is when a company repurchases its own shares in the marketplace. The practice returns money to investors by boosting the share price. It's also likely to reduce the number of shares outstanding, thereby boosting key performance metrics such as earnings per share.

US companies have been spending colossal amounts buying back their own shares over the last couple of years, after periods of strong profits left them with spare cash. S&P 500 companies are likely to spend in the region of $1 trillion on buybacks this year, analysts say, after purchasing a record $882 billion in 2021.

Derren Nathan, head of equity research at broker Hargreaves Lansdown, told Insider the Democrats' proposed 1% tax will impact companies' thinking.

"This move may cause board members to think twice about pulling that lever," he said. "1% might not seem huge, but with buyback programs often in the billions of dollars, the cash and earnings impact is not to be underestimated."

A person familiar with the matter told Insider that the 1% buyback tax would raise considerably more money than the now-removed carried interest provision, which was expected to generate around $14 billion.

The buyback tax is aimed at limiting a practice which many politicians and analysts have criticized. Opponents say buybacks enrich company shareholders and executives and discourage investments for the future in workers and machinery.

Tech companies, whose stock prices have been battered in 2022 after a surge during the pandemic, are some of the biggest practitioners of buybacks. Apple announced a whopping $90 billion buyback scheme earlier this year, and Microsoft unveiled a $60 billion plan in September last year.

Laidler said that although the 1% levy will not be welcomed by investors, companies are still likely to pay the same amount of money out by increasing dividends.

"I think the impact here is going to be more about how we cut the shareholder returns pie, rather than does it make any big changes to company investment," he said.

Stock market investors and company boards have bigger concerns right now, he said. Not least surging inflation, Federal Reserve rate hikes, and the threat of recession. US markets were little changed on Friday morning, with S&P 500 futures slightly in the green.