Policy Brief: Back to Basics for Corporate Finance

What’s the Problem?

• Most activity in financial markets has become disconnected from productivity and now entails extracting capital from the real economy and generating profit through financial engineering.
• Domestic business investment is in long-term decline, American industry has been hollowed out, and companies are disgorging cash so quickly that they cannot even maintain their existing capital bases.
• To further amplify shareholder returns, firms are leveraging their balance sheets with tax-advantaged debt that discourages investment, reduces resilience, and shifts risk on to workers.

U.S. Investment Is Dropping

Companies operating in the real economy are supposed to raise capital from investors in financial markets, grow their businesses, and return some of the profits as dividends. But this is no longer the case in the U.S., where business investment has fallen significantly as a share of GDP. The corporate sector has become a net lender, handing capital back to financial markets and cannibalizing existing operations to boost short-term shareholder returns.

Firms use stock buybacks to manipulate and boost stock prices, while helping investors defer tax liability. Annual buybacks now total $1 trillion, roughly double the amount returned through dividends. Allowing interest deductability, meanwhile, encourages firms to prefer debt financing over equity and pursue highly leveraged business strategies. Corporations must pay tax on their profit before paying dividends, but they can pay interest with pre-tax dollars. Corporate debt levels are at record highs, and leave businesses more susceptible to economic shocks, more likely to be the source of an economic shock, and more likely to cut jobs in response. Rather than borrow to invest, companies often take on debt merely to fund even larger payouts back to shareholders.

What’s the Solution?

Congress can discourage both practices through straightforward legislation.

Indeed, stock buybacks were illegal until the SEC promulgated Rule 10b-18 in 1982 to provide them safe harbor from insider trading prohibitions. The Tax Cut and Jobs Act of 2017 capped interest deductions at 30% of taxable income.

Congress should pass legislation that repeals Rule 10b-18 and amends the tax code to prohibit all deductions of interest payments from business income.

Encouraging Productive Investment

With these changes in place, firms would remain free to return capital to shareholders via the traditional and transparent method of dividend payments. They would also remain free to acquire financing with debt.

But they would no longer have special tax incentives to engage in financial engineering and tax avoidance while reducing productive investment and increasing risk.

The tried-and-true practice of earning a profit through investing in growing a business would become relatively more attractive.

Frequently Raised Objections

• Oren Cass. “Confronting Coin-Flip Capitalism.” American Compass, 2021. A pro-market agenda for financial reform that includes this proposal.
• Oren Cass. “The Rise of Wall Street and the Fall of American Investment.” American Compass, 2021. A primer on how financialization erodes the American economy’s foundations.
• Oren Cass. “The Corporate Erosion of Capitalism.” American Compass, 2021. A report analyzing declining business investment in the United States. 
• William Lazonick, “Profits Without Prosperity.” Harvard Business Review, 2014. A seminal essay describing the pitfalls of share buybacks and the collapse of business investment.