American tax system favours the rich
The recent change in the corporate tax rate in the U.S. illustrates one of the major biases in the tax system that favours the rich and increases the inequality of income and wealth.
With the corporate tax rate reduced from 35 to 21 per cent, corporations that had kept profits overseas now find it worthwhile to repatriate those earnings. The Republican majority promoted the change, saying that the returning off-shore funds would now be used to make domestic investments thereby strengthening the manufacturing sector in the U.S. This is one of President Donald Trump’s prime economic objectives.
Unfortunately, the reform is not always panning out as anticipated. Some companies have used a significant portion of the freed-up funds to pay bonuses to their employees. Others have already made some new investments in plant and equipment. But, many have decided they want to use the funds to buy back their own company’s stock. They could as easily distribute the funds to the shareholders in the form of dividends, thereby allowing investors to keep their shareholdings constant while enjoying increased income. But, stock buybacks are the option chosen most frequently by corporate boards and management.
Why? Well, let’s consider what happens to the value of the remaining shares after say 10 per cent of the outstanding shares are bought back. Assume the value of the company before the buyback was $10 million with one million outstanding shares trading at $10 per share. After a buyback of 100,000 shares, the value of each share remaining is now $11.11. Each share has a realizable capital gain of $1.11. Shareholders, if they wish, can sell their shares or continue to watch their shares increase in value
Investors also enjoy a favourable rate of tax on this appreciation of the value of their shareholdings because capital gains are taxed at a lower rate than regular earned income. This difference in the rate of taxation is intended to compensate investors for taking the risk of holding company shares. Now, let’s look at the case of the corporation’s directors and senior management. Assume the directors are paid a yearly stipend of, say, $200,000 and receive stock options as well. Senior management, who are also granted stock options, may earn multimillions in annual salaries. After three or four years at that level of pay, they can anticipate a very comfortable retirement.
Favourable tax treatment of capital gains makes it attractive for these company insiders to receive grants of equity rather than taking all their income as salary. A stock buyback — which they have decided is a better use of cash than investing in plant and equipment — is doubly beneficial. It’s a largely risk-free way to enhance their holdings while getting a good deal from the taxman.
Ordinary people who own houses may realize capital gains when selling their principal residences and those gains are tax-free. Homeowners living in Vancouver and Toronto have, in recent years, realized very substantial gains. However, a strong case can be made that the risk in owning a residence is minimal so a question arises as to the wisdom of windfall gains being free of tax.
The Royal Commission on Taxation back in the 1960s recommended that all income — no matter how earned — should be taxed at the same rate. “A buck is a buck,” they said. That proposal was tenaciously fought by the wealthy elite and never put into action.
Then, 20 years ago, one renegade investor recommended that each individual be allowed a lifetime amount of capital gains free of tax and that once that amount had been reached all further gains be taxed as regular income.
Such a change in the tax policy would, in the case of corporate finance, lessen the attraction of share buybacks and, in the case of real estate, lessen the upward pressure on prices. It would also, in time, lessen the disparity in both income and wealth.
David Bond is a retired bank economist who resides in Kelowna. To contact the writer: curmudgeon@harumpf.com. This column appears Tuesdays.