Where good intentions go to die!

Before we get started, I don’t do politics here unless there is a broadly applicable lesson and it affects markets. You shouldn’t read into any of what follows as an endorsement of one party or a denouncing of the other.

That said, there are some pretty good lessons about unintended consequences from the recent bills to help the semiconductor industry and the climate compromise bill.

The lesson is the real world impacts will be far different from what any of the Senators hope to occur.

The Buyback Tax

Let’s start with the climate bill or inflation act or whatever you prefer to call it. There was a last minute provision put in the bill that I don’t think many people noticed.

Senator Synema refused to end the carried interest tax treatment (as someone who has previously benefited from it at times, I can tell you there isn’t much justification for keeping it) and demanded an alternative “Wall Street tax”.

What we got instead is a tax on stock buybacks. Namely, companies will pay 1% of their buybacks in tax, so $1M of tax for $100M of buyback.

I wrote about why this was a bad idea when it was originally proposed by Senator Warren. That analysis still stands and I’ll repeat it pieces of it here. The short version is the alternatives to buybacks are far worse than allowing buybacks.

Changing Incentives

However, there is something far more ironic and convoluted here. Buybacks aren’t going to slow because of this tax. I wouldn’t even be surprised if they ultimately increase. You know why?

The tobacco tax! Remember, how once the government settled with the tobacco industry and state revenue was dependent on tobacco sales, all of a sudden, the government stopped trying to eliminate tobacco.

Well, the same thing will happen here. Any populist politician who rallies against buybacks will get kicked hard under the table by their nearest colleague.

Buybacks now raise revenue! The government requires buybacks to afford more spending. Therefore, they will seek more of them, not less.

Finding Loopholes

As for companies, they will complain, but learn to live with it. As much as I think taxing buybacks is irrational and unjustified, at a 1% tax, companies aren’t going to suddenly pay dividends that individuals (including executives) are taxed at as much as 50% depending on what state you live in.

Plus, there’s a carrot in here that really avoided attention. Apparently, there are exceptions for buybacks that offset stock option issuance. Yep, you know where I’m going.

Management teams now have even more incentive to grant themselves more stock. After all, it’s the only way to do buybacks without paying tax! This is a huge handout to tech companies as well as CEOs who think shareholders can’t calculate share counts properly (truth is, most can’t).

But the best part is all the same Senators who are against buybacks are also against excessive CEO pay. But since they taxed CEO pay >$1M a few years back, the incentive to use equity comp instead keeps getting higher and higher. With the buyback bill’s loophole for stock compensation, expect even bigger grants for everyone!

So get ready for record buybacks, which is actually good news, because as I pointed out in the original post, the last thing you want is a CEO who has too much capital and a penchant for spending it on stupid things like bad acquisitions or vanity capital projects.

The Semi Bill

Speaking of vanity capital projects, let’s talk about the other bill that was passed recently. I’ve also written before about the risk to semiconductor availability and that semis today could pose the risk that oil shortages did to the world economy in the 70s.

So the instinct for Congress to do something to diversify supply away from a very vulnerable Taiwan is sound. However, there is a big difference between sound instincts and effective actions.

First, let’s review how we got here. US plants can’t make semis as cheaply and efficiently as Taiwan. Thus, markets preferred to buy from Taiwan. Makes sense. Ricardian Advantage at work.

Risk Adjusted Ricardian

Well, sort of. It makes sense at the mean. It does not make sense in the tails and tail events do happen. Thus, the reason to have some domestic capacity, even if not truly competitive, is because in a tail scenario it will be cheaper. For example, imagine if Germany had local gas sources instead of being reliant on Russia.

So we all understand by now the rationale to have some “uncompetitive” capacity to prevent shortages. However, is giving US manufacturers handouts to build new capacity the solution?

No Free Lunch

If it were, I wouldn’t have asked the question! There are a few problems here. First, there is no incentive for US plants to become competitive. Normally, when you subsidize something (like higher education), it gets more expensive, not less.

Second, these plants now become political symbols. You can bet certain politicians will start railing against “Big Semi” if they don’t bring down prices further or if they need to do layoffs to “make profits for greedy CEOs”. They have stepped into a maelstrom.

Fixing Incentives

The way to actually solve the problem is to align incentives. Tie the subsidies to competitiveness. The government pays more if the cost is within 10% of international markets. It pays less if it is say 25% or more above.

Now, the companies are motivated to chase the carrot and become world class competitors because they get a prize for it (which will result in higher margins and higher stock prices). If they can’t do it, then the government subsidy is lower and the politicians are happy.

If you want an alternative to a success fee, the government can create a “reverse tariff” where domestic buyers of semis can get a 10% credit for buying from a US producer. This would only make sense if US suppliers can approach the cost of foreign producers. While not as efficient as the success fee, it would induce US companies to buy American.

But alas, nobody in the Senate was adroit enough to come up with this idea so instead we get big fat payouts that will drag the industry into politics and make them less competitive over the long run.

The Principal-Agent Problem

These two bills both show the big problem with asking elected officials to solve our problems. They inevitably do what is in their best interest, not yours. This is called the principal-agent problem and I could write a whole ‘nother post just on that topic.

Suffice it to say, politicians are motivated by things that get them re-elected. Passing bills that appear to do something popular help with that cause. Whether the legislation is actually successful is most often irrelevant. You can always blame someone else later and evade consequences!

And yes, principal-agent conflicts explain a lot of suboptimal CEO behavior as well. Note, the stock option example from above.

There isn’t a whole lot we can do to remove agency conflicts from politics without some really significant constitutional amendments. However, you can lower your expectations when you hear of these bills being passed and realize the reality will likely be far different from the messaging.