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Share buybacks let income inequality grow

Pope Francis is talking about it. So is U.S. President Barack Obama, half the prime ministers in Europe and any number of institutional investors and shareholder activists. The gap between the rich and everyone else has become obscene and potentially destabilizing to societies, especially in the countries worn down by double-digit unemployment. But no one seems to know what to do about inequality.

Raising taxes is the logical answer, and taxes have indeed been raised. The effort has been flawed, haphazard and sometimes counterproductive. Boosting the value-added taxes (VAT, equivalent to Canada's harmonized sales tax) in Europe has hurt the poor and damaged the economic recovery without causing the slightest discomfort to the rich. Whacking the rich hasn't worked.

In France, President François Hollande's 75-per-cent marginal tax rate on higher earners has triggered a wealth exodus. A less extreme global wealth tax makes a lot of sense, but convincing dozens of countries to agree on its design and implementation would be next to impossible.

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Here's a simpler idea to reduce inequality in the United States, Canada, Britain and a few other economies where the capital markets are skewed toward the rich: Ban, or at least rein in, share buybacks.

Buybacks are such a common feature of corporate life and the stock markets that it's easy to forget that they were essentially illegal not too long ago. They are used to manipulate share prices and earnings per share, all in the name of "maximizing shareholder value." The result has been an explosion of wealth among executives who are typically loaded with stock-based pay and who enjoy the luxury of determining the amounts of the buybacks as well as their timing. As buybacks increased in frequency and value, so did the share of executive pay in the form of stock options and stock awards.

The result was a positive feedback loop that enriched all executives and handed a few unimaginable wealth.

A new research paper written by William Lazonick of the University of Massachusetts Lowell, which will be presented at the conference of the Institute of New Economic Thinking in Toronto on April 10 to 12, noted that in 2012, the 500 highest-paid executives in the United States received an average pay of $24.4-million (U.S.) – 52 per cent from stock options and 26 per cent from stock awards.

"The more one delves into the reasons for the huge increase in open-market [share] repurchase since the mid-1980s, the clearer it becomes that the only plausible reason for this mode of resource allocation is that the very executives who make the buyback decisions have much to gain personally through their stock-based pay," Mr. Lazonick said.

As executive pay soared, workers' wages stagnated when measured against productivity gains. Between 1948 and 1983, when regulations severely limited the size of buybacks, real compensation per hour and gains in productivity per hour closely tracked one other. That's no longer the case. In the early 1980s, a significant gap between productivity and wages emerged and kept getting wider. By 2012, the 100-per-cent rise in productivity (partly due to corporate "downsizing") from its level in 1963 was met with a mere 60-per-cent increase in real wages.

There's nothing wrong with executives getting rich as long as the gains translate into shared prosperity. That's not happening, and the buyback explosion can take a lot of the blame.

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The trigger point came in 1982, when the U.S. Securities and Exchange Commission used Rule 10b-18 to haul buybacks out of the shadows. In essence, they legalized large-scale buybacks. Open-market share purchases would be allowed if on any given day they did not exceed 25 per cent of the company's average daily trading volume over the previous four weeks. Before then, the de facto limit was 15 per cent.

The rule was a godsend to stock-based pay, and buybacks climbed. Between 2001 and 2012, the S&P 500 companies spent an astounding $3.5-trillion on buybacks, an average of $600-million per company per year (perversely, the buybacks peaked in 2007, the pre-crash year, destroying the boardroom argument that buybacks were launched because executives believed their companies' shares were fundamentally undervalued).

Some companies practised the art with abandon. Exxon Mobil spent $207-billion buying back shares between 2003 and 2012, equivalent to 60 per cent of its profit over those years. Cisco Systems and Hewlett-Packard spend more than 100 per cent of their profit on buybacks. Canada's BlackBerry and Finland's Nokia launched huge buybacks even as their market shares were collapsing. Imagine if they had devoted those fortunes to innovation instead?

Pope Francis has made criticism of the excesses of capitalism one of his big themes. He wasn't of course talking about stock manipulation and executive pay when he came down on a system "which tends to devour everything which stands in the way of increased profits," but he could have been. The galloping pace of share buybacks is creating undeserved profits for executives. It's time to go back to the pre-1982 era, when they were a rarity.

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About the Author
European Columnist

Eric Reguly is the European columnist for The Globe and Mail and is based in Rome. Since 2007, when he moved to Europe, he has primarily covered economic and financial stories, ranging from the euro zone crisis and the bank bailouts to the rise and fall of Russia's oligarchs and the merger of Fiat and Chrysler. More


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