It’s possible that sluggish business investment reflects lack of confidence in the economic outlook –… that’s understandable given the bursting of the housing bubble…But…there is a more disturbing possibility. Instead of investing in physical capital, many companies are using profits to buy back their own stock.
Here are longer excerpts. Of course stock buy-backs do not take away resources for subsequent investment. The money used to buy shares can still be funneled into the purchase of capital goods, as no real opportunities have been taken off the table.
That said, cash "in the firm" is more likely to be invested than "cash in the hands of investors," for reasons of credit rationing and other institutional rigidities (for instance borrowing money brings more outside scrutiny). Given the size and profitability of these firms, however, I do not expect that the credit rationing effect is a large one. The causes of the sluggishness of investment are thus to be found elsewhere than through this financial mechanism.
Here is my earlier post on the Junker fallacy. I believe this sort of argument was first criticized by Fritz Machlup in his book on the stock market. Of course if you wish to save the claim through various second best arguments, comments are open…
It is a myth resulting from bad government accounting that US businesses are underinvesting. Which is not to say there isn’t “enough” investment in the US (although there may be enough), whatever “enough” means. But corporate America is in no danger from underinvestment.
happy, isn’t corp tax thing likely to work both ways, debt shield to save on taxes(buybacks) and capital investment(depreciation shield). assuming a st line method of deprecation an interest rate of 6% should equal a useful life of 16 yrs. it appears to me that companies can choose either route.
Tyler,
Sorry about not posting on the Junker line of thought, I was concentrating on the first part of the thesis that US corporate investment is low, not on the “dissappearing money syndrome” (my phrase) that Krugman is worried about.
Lannychiu is right that there is no economic difference between dividends and stock buybacks, just a substantial tax difference. So if Krugman has a problem with stock buybacks he also ought to have a problem with dividends.
The real reason why companies are buying bakc their stock is because debt is cheaper than the earnings/price ratio, and this is also the reason for the LBO boom (er, I mean private equity boom, sorry to not be pc). Companies to a large extent are not leveraged enough.
The notion that this phenomenon is about disintermediation strikes me as backwards. If anything it is about taking debt capital, which to a decent extent is coming from risk averse foreigners, and using it to invest in higher “yielding” (i.e. e/p ratio, not price/dividend ratio) equities. Thus there is a crowding in of investment from debt financed share buybacks, not a crowding out.
Your analysis that a high chunk of the sellers in buybacks will reinvest somewhere is indeed the most likely scenario. That fact by the way argues for eliminating all investment taxes and replacing them with tax increases elsewhere (or better yet spending cuts) since those non-investment activities are less likely to result in investment than currently taxes investments which would mostly reinvest any tax savings.
The real reason why companies are buying bakc their stock is because debt is cheaper than the earnings/price ratio,
Ahem. The real reason companies are buying back stock is because it is the most tax-efficient way to return capital to shareholders.
(I know, I know, I’m dead. But I’m still right!)
spencer,
Interesting numbers. I am curious (and ignorant here), but do those numbers take into account profits earned abroad but aren’t repatriated? In other words, if IBM earns $x in India and repatriates $0.1x, reinvesting the other 90% in India, does that count as a $0.1x inflow into the US or a $0.8x net outflow?
asiequana,
Foreign countries also have deductions. Also countries have been known to give out a 0% tax rate, or a negative one all-in, to corporations to invest there. Just ask Intel.
I am still inclined to think that the US rate, even after adjusting for deductions, is still much higher than almost everyone else.
Also, regardless of zero sum issues, investment is also a positive sum game. Taxing our most growth enhancing activities isn’t too smart. We subsidize human capital investment, but we tax investments in physical capital. The latter doesn’t make sense.
If not, it should pay out that capital, via a dividend or a stock buyback. The mechanics of returning the capital are irrelevant. Aren’t they? Am I missing something?
In a world of no taxes, they are equivalent. But dividends are paid to all shareholders, whether or not they want them, and are taxed at 15%. Buybacks are taxable only to the shareholder who sells his share to the company, and taxed at 5% ,15%, or ordinary rates, depending on his holding period.
So why do companies even pay dividends, rather than buying back shares? I posit that it is a costly signal to shareholders that the firm has fiscal discipline, and is confident in its ability to produce cash as a going concern.
happy juggler — your are right. this data does not include reinvestment of earnings made abroad — exactly what your example shows.
But remember for multinational corporations standard practice when they undertake a direct investment in a country is to borrow the bulk of the
money for that capital spending — new facility –in the currency of the
country they are investing in. If the new facility is to have a 20 year life, for example, you have no idea what is going to happen to exchange rates over that period. So it is just a prudent hedging technique to borrow in that currency for the bulk of the fixed investment. The equity in knowledge that the multinational brings to the table is really what is important in such transactions.
Happy juggler — I do a series of the US stock of fixed capital per employee.
The change in this series, lagged one year is a very important determine of productivity growth. It is essentially the Solow one-third of productivity we understand.
But, this variable has been stagnating for the last few years. From 1950 to 1980 the trend growth rate of this series was 1.6%. Since 1980 the trend growth rate has been 0.9%. It stagnated in the 1980s, rebounded strongly in the 1990s and has been flat since 2000. this series leads me to worry very much that the level of capital spending is inadequate. I’m of the old school that the way you increase productivity and standards of living is to increase the capital per employee.
On the direct investment data. it is highly volatile. But on a smoothed basis it consistently showed strong growth prior to 2000 — it is hard to show data on blogs so I limited the data to the last few years. Except for the one year of 2004 it has been very weak since 2000. There was a clear break in trend in 2000 when you look at a longer data series.
By the way, by their labor component is much higher, I am referring to the ratio actual work accomplished (via man or machine), not the ratio of the dollar cost of those two inputs.
Hmmm…Krugman committed yet ANOTHER fallacy. How many does he get before we stop considering him an economist anymore?
After reading more of Krugman’s article, another reason for rising corporate profits is that many unprofitable businesses from 2000 (or ones that were ‘manufacturing’ profits in their accounting department) are no longer in business, or have been reorganized.
Where Krugman might have had a point is that the US is borrowing heavily, and not significantly increasing its capital stock. Using a business analogy, you can borrow to build a factory, but don’t want to borrow to put TV’s in the break room and throw lavish parties.
US companies will continue their profitable ways, but a lot of those profits will head overseas to cover debts incurred.
Spencer – the reduction in rates on repatriated money was a temporary change in effect for 2005 (with an extension into 2006 for select firms).
Krugman’s initial statement (“It’s possible that sluggish business investment reflects lack of confidence in the economic outlook”) is illogical and just wrong.
I was hasty in dismissing Krugman’s initial sentence as illogical. Because PK inserts the word “possible” into the sentence, it isn’t illogical. But I’d say it’s a dishonest framing of the issue. Business confidence has been at pretty high levels in the last couple of years. The increased amount of share repurchases has many different causal factors, business confidence not being at the top of the list, I’d say.
happyj: glad to be of help.
When indivdiual tax rates on dividends and capital gains were equalized in 2003, that alleviated a distortion in corporate decisions to use stock buybacks (which raise earnings per share and generate capital gains) rather than dividend payouts. It also made grants of restricted stock marginally more attractive relative to nonqualified stock options, because owners of restricted stock collect dividends taxed at 15% while nonqualified options are taxed at rates up to 35% (albeit with tax deferral).
Stock buybacks don’t reduce capital spending any more than dividends do. Companies with subpar investment opportunities should not retain earnings for expansion rather than sharing earnings with stockholders through dividends or buybacks.
Krugman’s point is just wrong. Tyler is just right.
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