In a desperate effort to make the numbers in the Inflation Reduction Act work, Senate negotiators threw in a 1% tax on share buybacks by corporations at the last minute. Although the $74 billion projected to be raised by this tax is only a bit more than 0.1% of projected revenue over the next decade, it may prove to be one of the most important provisions in the new law.

There are two main reasons that this provision matters. The first is straightforward—while buybacks are often demonized for silly reasons, their current tax treatment is a very real issue. Share buybacks and dividend payouts are alternative mechanisms through which companies pay out profits to shareholders. Dividend payouts are directly taxed at the individual level. However, the money that companies pay out in buybacks, which gets to shareholders in the form of higher share prices, is not subject to tax.

There is zero logic to this asymmetry. The government has no reason to prefer that companies pay out money as share buybacks rather than dividends, but the tax treatment gives them a clear incentive to do so. As a result, the share of after-tax profits paid out as dividends fell to less than 43% in last decade from more than 56% in the 1960s, before the legality of buybacks had been established.

The wealthiest people are also likely to be the largest beneficiaries of this asymmetry. Taxes are only owed when stock is sold at a gain, and many of the wealthiest people will have little need to sell stock. They can put off the tax indefinitely and even pass on stock to heirs, without anyone paying capital gains tax.

Most middle-income stockholders have most of their stock in retirement accounts. For these people, the tax treatment of dividends and buybacks ends up being identical. All the returns in a 401(k) account are taxed as normal income when the money is pulled out.

In addition to reducing this asymmetry, the tax on buybacks has the advantage of taxing stock holdings that escape taxation. This would include stock holdings by foreign investors, who hold close to 40% of the market. To be clear, a 1% tax on buybacks is a relatively small step in this regard, but it is going in the right direction.

While reducing the asymmetry between the tax treatment of dividends and buybacks is a big deal, it’s the less important reason to be celebrating this provision of the new law. The taxation of share buybacks is a step toward moving away from basing the corporate income tax on profits, which are far from transparent, to taxing returns to shareholders, which are 100% transparent.

The point here is straightforward. The IRS has no direct way of knowing how much profit a company has made. It relies on corporate accountants to apply rules on depreciation, expenses, and many other factors that allow them to determine how much of a company’s revenue is profits.

Needless to say, corporate accountants have an enormous incentive to minimize the profits reported to the IRS. They employ a wide variety of tactics—some of them legal and some of them dubious—to make their profits subject to the US tax appear as small as possible.

In some cases, they can be tremendously innovative in having US profits appear as profits earned in tax havens like Ireland or the Cayman Islands. They also have developed very creative mechanisms for deferring profits to periods where it might be more convenient to recognize them. And sometimes, they just cheat.

Basing the corporate income tax on returns to shareholders (capital gains and dividends) removes this problem altogether. These are numbers that are immediately available on any financial website. They are simply the increase in market capitalization over the tax year, plus dividend payouts.

The IRS could quickly compute the tax liability for every publicly traded company in the country on a single spreadsheet. It may be desirable to allow multi-year averaging to smooth out tax liabilities and to have some rule to allocate tax liability over national jurisdictions. But these problems are trivial compared to the issues the IRS faces in reviewing profit calculations.

We can still debate the tax rate we want to impose—the point is that we can count on actually collecting whatever tax rate Congress sets. While the nominal tax rate is 21%, in 2019, corporations paid just 12.2% of their profits in tax.

Even more important than collecting the targeted revenue, the switch to basing the corporate income tax on returns to shareholders largely will eliminate the tax shelter industry. All the accountants and tax lawyers who make big salaries by finding creative ways to reduce corporations’ tax liability will instead have to find productive work to support themselves. The IRS also could radically reduce the size of its staff devoted to monitoring corporate income tax returns.

A 1% tax on share buybacks is, of course, far removed from changing the basis for the corporate income tax from profits to returns to shareholders. However, it is a huge first step. After this measure is in place for two or three years, it will be possible to compare the targeted revenue with what the government collects. We will also have good data on the cost of enforcement, which is likely to be trivial since the money spent on buybacks is fully transparent.

This should create support for going further. It makes more sense to tax the returns to shareholders that we can see than to tax corporate profits that corporate accountants calculate for us. Getting a foot in the door with this tax on buybacks should help make this point apparent to everyone.

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