On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (TCJA), which is the largest gross tax cut in American history (cutting more than $5.5 trillion in taxes over 10 years); the act took effect on January 1, 2018. The TCJA has two key elements: (i) a reduction in the corporate income tax rate from 35 percent to 21 percent, and (ii) a one-time tax holiday that cuts the tax on cash repatriation from foreign subsidiaries from 35 percent to 15.5 percent. Furthermore, in connection with (ii), the U.S. corporate tax system also moved from a worldwide tax system to a hybrid territorial system in which taxes on foreign profits are unrelated to the repatriation of these profits. Thus, the TCJA reduced the tax incentive for U.S. corporations to hold cash overseas by reducing tax-related frictions in the operation of their global internal capital markets.
What should we expect the effects of these tax cuts to be on U.S. corporations? This is the question we tackle empirically in our recent working paper, “Stock Repurchases and the 2017 Tax Cuts and Jobs Act.” The intent of the TCJA, as stated by the administration and suggested by the name of the act, is to stimulate corporate investment and employment. Critics of the act, including those in the financial media, have argued that its effect was predominantly to enable U.S. corporations to use the tax-related cash windfall to repurchase stock and that corporations did not invest more and boost wages.
Theoretically, Brennan and Thakor (1990) find that “for larger distributions an open market stock repurchase is likely to be preferred by a majority of shareholders.” Empirically, Brav, Graham, Harvey, and Michaely (2005) report that “many managers now favor repurchases because they are viewed as being more flexible than dividends and can be used in an attempt to time the equity market or to increase earnings per share.” Thus, both theoretically and empirically, we expect firms to spend more of the TJCA windfall on repurchases than on dividends.
Theory also suggests that a cut in the corporate income tax rate increases the expected future cash flows on projects, thereby increasing their values (NPVs), so there will be more positive-NPV projects available to firms. Other things being equal, this should lead to an increase in corporate investment and possibly wages if the demand for labor increases with investments. The impact on investment may be affected by the firm’s pre-TCJA leverage. Highly levered firms may be concerned about debt overhang and may thus use the cash windfall primarily to pay down debt, whereas firms with lower leverage may use it to invest more. In contrast, a reduction in the repatriation tax on foreign earnings has no direct effect on the NPVs of projects available to firms, but it does provide a cash windfall. Thus, we should expect its predominant effect to be an increase in stock repurchases and possibly dividends.
Using monthly stock repurchase data collected from firms’ SEC 10-Q and 10-K filings, we show empirically the existence of both of these theoretically-predicted effects. Specifically, in contrast to media accounts, our study provides causal evidence that the cut in the corporate income tax rate was not the main driver of the increase in share repurchases. Rather, it was the cut in the repatriation tax and the transition towards a territorial tax system that drove the surge in buybacks. The cut in the corporate income tax rate was primarily responsible for higher investments and debt reductions.
We first study the effect of the repatriation tax cut in the TCJA. Our empirical analysis starts with tests on the potential channels through which the TCJA affects repurchases. We use two settings to test the repatriation-tax related effects. In the first setting, we argue that firms with more foreign profits benefited more from the repatriation tax cut and in turn repurchased more than those with less or no foreign profits. This is confirmed by the data. We also find an increase in dividends by these firms, so total payouts increased. In the second setting, we exploit the cross-sectional variation in state-level repatriation tax cuts. For state income tax purposes, a firm in a state that does not conform to the TCJA repatriation tax cut needs to add back the repatriation tax deduction. This rule reduces the repatriation benefit when paying state-level taxes. Firms headquartered in states conforming to the TCJA repatriation tax cut are, therefore, predicted to repurchase more than others do. This is also confirmed by the relevant tests. Both settings provide supporting evidence for the repatriation effect of TCJA on repurchase.
We further test the possible effects of the corporate income tax cut on repurchases (element (i) of the TCJA) and use two different settings for this as well. In the first setting, we argue that, if the income tax cut is the main driver of the large repurchases, firms with high pre-TCJA tax rates would buy back more shares than those with low pre-TCJA tax rates. However, this is not supported by the data. We then use the second setting in which we consider only domestic firms: These firms are unlikely to be affected by changes in repatriation-related tax laws. The evidence shows that within this set, high-tax and low-tax firms behave similarly in increasing repurchases following the TCJA. This is consistent with the evidence under the first setting and buttresses the finding that the income tax cut is not the main driver of the increase in repurchases following the TCJA.
Next, we provide evidence related to two concerns about the increase in repurchases following the TCJA. The first is about the efficiency of repurchases following the tax windfall. Do managers waste the tax windfall and repurchase at relatively high prices, or do they time the market and repurchase at favorable prices? We find that firms with large foreign profits are especially efficient in their repurchase activity. While other firms do not show the same ability, they do not buy back at high prices either. Furthermore, we find that the market reaction to the new repurchase announcements (following the TCJA) by firms with large foreign profits is significantly positive. Our findings show that some firms do appear to time the market in their repurchases following the TCJA.
The second concern is about the role of executive incentives. Jensen’s (1986) free cash flow hypothesis suggests that managerial stockpiling of cash within the firm may yield private benefits to managers but hurt shareholders’ interests. Therefore, we should expect that CEOs whose wealth is more tied to their firms’ stock prices – and thus have interests more aligned with those of shareholders – will repurchase more to disgorge excess cash and reduce free-cash-flow inefficiencies. We find that they do. We also find evidence that employees’ ownership influences firms’ repurchase decisions. In particular, we document that firms with Employee Stock Ownership Plans (ESOPs) buy back more shares after the TCJA than those without ESOPs, which highlights a largely-overlooked benefit of the TCJA for workers.
We further identify a spillover effect of the repurchases by multinational corporations (MNCs) with large foreign profits. In particular, when MNCs in an industry repurchase more shares, the domestic firms in the same industry also repurchase more, which is consistent with the mimicking repurchases documented by Massa, Rehman, and Vermaelen (2007).
We also study the effect of the income tax cut in the TCJA on other corporate policies. In particular, we investigate the effects of the TCJA on corporate investments, leverage and wages. We find that financially-constrained firms with high income taxes increase investments moderately, consistent with the theory. Moreover, highly-levered firms with high income taxes reduce leverage significantly. We do not find a significant increase in wages due to the TCJA. However, the reduction in leverage is a de facto increase in expected wages, according to the human-capital based theory of optimal capital structure in Jaggia and Thakor (1994). The effect on investment is weaker than the effect on repurchases.
This post comes to us from professors Benjamin Bennett at Tulane University, Anjan V. Thakor at Washington University in St. Louis, and Zexi Wang at Lancaster University. It is based on their recent paper, “Stock Repurchases and the 2017 Tax Cuts and Jobs Act,” available here.