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My (limited) understanding is that dividends and share repurchases are economically very similar: while share repurchases are slightly less direct, both transactions are effectively ways for publicly traded companies to transfer wealth to their shareholders.

From what I can tell, the only real difference between these two transactions is the way that the tax code treats them: (non-qualified) dividends are taxed as ordinary income, while the gains resulting from share repurchases are taxed as capital gains. Companies often prefer to make share repurchases because they are effectively taxed at lower rates.

It seems to me that there's a likely inefficiency whenever effectively equivalent transactions are taxed at different rates. Is there some important difference between dividends and share repurchases that I'm missing that justifies the tax code's differential treatment?

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  1. Dividends have to be taxed as income, as otherwise people can incorporate, have their wages taxed as revenue for the corporation, and then pay themselves a dividend. (Canada adjusts taxes on dividends in an attempt to make these two approaches equivalent for taxes purposes.)
  2. Capital gains are at a lower rate for reasons that are debatable. However, in order for a gain to qualify as a capital gain, the principle is that there has to be a possibility of a loss. (To what extent that principle is achieved can be debated, since there is an incentive to exploit this lower tax rate.) In the case of share buybacks, even though the firm is purchasing shares, there is no guarantee that the sellers are selling at a profit.

I am a consultant in Canada, and one of the first things to decide is whether to form a corporation or not. The logic varies upon the tax code in each jurisdiction. The following article discusses the situation in the United States: link to small business advice website.

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  • $\begingroup$ 1. Would it be that easy? If you incorporate as a publicly traded company, then wouldn't other people be allowed to by shares in you and then be entitled to a fraction of your wages? $\endgroup$ – tparker Jul 23 '20 at 0:54
  • $\begingroup$ 2. Suppose for the sake of argument that you completely buy into the Chamley-Judd argument and think that capital gains should not be taxed at all. Can you give me some intuition for what that that economic perspective would say is the qualitative difference between dividends and share buybacks that leads to the result that dividends should be taxed and share buybacks should not? Surely it's more than just the fact that things that income streams that can lead to a loss should not be taxed, or you would argue that winnings from gambling should not be taxed. $\endgroup$ – tparker Jul 23 '20 at 0:56
  • $\begingroup$ 1) This would be a private corporation. Tax laws are fairly similar for private and public corporations. 2) A dividend is a transfer of income to all owners, and the owners have no risk in the transaction. A buyback buys shares from somebody, and that somebody may have sold at a loss - i.e., gains/losses are at a risk. $\endgroup$ – Brian Romanchuk Jul 23 '20 at 1:52

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