Dividends and buy-backs are not economically equivalent

Continuing the discussion from America's CEOs and hedge-funds are starving the nation's corporations to death:

I read it as you saying that, having got the dividend, the investor could simply reinvest it in the same stock, and that would be equivalent to a stock buy-back. And of course it’s not, as I and others explained. But even if it were a special dividend-like event where you could either take your dividend or get more stock, it’s still not equivalent, because the tax implications are the same for both a regular dividend and your special dividend-like event.

It’s only the straight buy-back that doesn’t have those tax implications for people who didn’t sell back their stock: their stock is now increased in value, but they owe no tax, because no tax-triggering event has occurred. Consequently, we can expect investor’s behavior to be different. To make the two transactions economically equivalent, any stock buy-back would have to trigger a tax event for all holders of that stock, and that event would have to treat the cash paid for stock as being divided up just as the equivalent dividend would have been.

Because it doesn’t work this way, we have a loophole, and it’s a loophole that actually encourages a really unfortunate result in the operation of the stock market: treating stock price as the dog, when it’s really the tail. Profitability is the dog, but because this loophole exists, the tail tends to wag the dog rather than vice versa, and this has really damaging consequences for companies’ long-term sustainability, and therefore ultimately for the investor, who has to hope that he or she gets off the bandwagon before it crashes. Ideally we’d want the incentives to reward both the speculator and the long-term investor, but unfortunately we see the opposite: the speculator is being rewarded at the expense of the long-term investor: essentially a transfer of wealth from savers to speculators.

Perhaps it’s silly to belabor this point, but this kind of hand-waving is really a problem in financial circles. Things that really are not equivalent are spoken of as being equivalent. As far as I can tell this is in hopes of shearing the sheep, and that’s a really bad way for a financial system on which all our comfortable retirements depend to function.


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