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5 years afterward the official stop of the Great Recession, corporate profits are high, and the stock market is booming. Withal most Americans are not sharing in the recovery. While the acme 0.one% of income recipients—which include virtually of the highest-ranking corporate executives—reap almost all the income gains, skilful jobs keep disappearing, and new employment opportunities tend to be insecure and underpaid. Corporate profitability is non translating into widespread economic prosperity.

The resource allotment of corporate profits to stock buybacks deserves much of the blame. Consider the 449 companies in the Southward&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their earnings—a total of $2.4 trillion—to purchase back their own stock, almost all through purchases on the open market. Dividends captivated an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees.

The buyback wave has gotten and so big, in fact, that even shareholders—the presumed beneficiaries of all this corporate largesse—are getting worried. "It concerns us that, in the wake of the financial crisis, many companies accept shied away from investing in the time to come growth of their companies," Laurence Fink, the chairman and CEO of BlackRock, the world'south largest asset managing director, wrote in an open letter to corporate America in March. "Besides many companies have cut capital expenditure and even increased debt to heave dividends and increase share buybacks."

Why are such massive resource being devoted to stock repurchases? Corporate executives give several reasons, which I will discuss after. But none of them has close to the explanatory power of this simple truth: Stock-based instruments make upwardly the majority of their pay, and in the brusque term buybacks drive up stock prices. In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company's shares, open-marketplace buybacks automatically lift its stock price, even if only temporarily, and tin enable the company to hitting quarterly earnings per share (EPS) targets.

Every bit a result, the very people we rely on to brand investments in the productive capabilities that will increase our shared prosperity are instead devoting virtually of their companies' profits to uses that volition increment their ain prosperity—with unsurprising results. Fifty-fifty when adjusted for inflation, the compensation of top U.South. executives has doubled or tripled since the kickoff half of the 1990s, when it was already widely viewed as excessive. Meanwhile, overall U.S. economic performance has faltered.

If the U.Southward. is to achieve growth that distributes income equitably and provides stable employment, government and business leaders must take steps to bring both stock buybacks and executive pay under command. The nation's economic health depends on it.

From Value Cosmos to Value Extraction

For 3 decades I've been studying how the resource allotment decisions of major U.Southward. corporations influence the relationship between value creation and value extraction, and how that relationship affects the U.S. economy. From the end of Globe War Two until the late 1970s, a retain-and-reinvest approach to resource allocation prevailed at major U.S. corporations. They retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater task security, thus contributing to equitable, stable economic growth—what I call "sustainable prosperity."

This blueprint began to break down in the late 1970s, giving style to a downsize-and-distribute regime of reducing costs and then distributing the freed-up cash to financial interests, particularly shareholders. By favoring value extraction over value cosmos, this approach has contributed to employment instability and income inequality.

As documented by the economists Thomas Piketty and Emmanuel Saez, the richest 0.1% of U.Due south. households collected a record 12.3% of all U.S. income in 2007, surpassing their 11.5% share in 1928, on the eve of the Great Low. In the financial crisis of 2008–2009, their share savage sharply, only it has since rebounded, hitting xi.iii% in 2012.

Since the late 1980s, the largest component of the income of the top 0.i% has been compensation, driven by stock-based pay. Meanwhile, the growth of workers' wages has been dull and sporadic, except during the internet boom of 1998–2000, the only time in the by 46 years when real wages rose by two% or more for iii years running. Since the belatedly 1970s, average growth in real wages has increasingly lagged productivity growth. (See the showroom "When Productivity and Wages Parted Ways.")

From 1948 to the mid-1970s, increases in productivity and wages went hand in hand. Then a gap opened betwixt the two.

Not coincidentally, U.S. employment relations have undergone a transformation in the by three decades. Mass plant closings eliminated millions of unionized blue-collar jobs. The norm of a white-collar worker's spending his or her entire career with ane visitor disappeared. And the seismic shift toward offshoring left all members of the U.Southward. labor force—even those with advanced instruction and substantial work experience—vulnerable to deportation.

To some extent these structural changes could exist justified initially as necessary responses to changes in technology and competition. In the early 1980s permanent institute closings were triggered by the inroads superior Japanese manufacturers had made in consumer-durable and capital letter-goods industries. In the early 1990s ane-company careers fell by the wayside in the It sector because the open-systems architecture of the microminiaturization revolution devalued the skills of older employees versed in proprietary technologies. And in the early 2000s the offshoring of more-routine tasks, such equally writing unsophisticated software and manning customer phone call centers, sped up as a capable labor force emerged in low-wage developing economies and communications costs plunged, allowing U.S. companies to focus their domestic employees on college-value-added piece of work.

These practices chipped away at the loyalty and dampened the spending power of American workers, and ofttimes gave away key competitive capabilities of U.S. companies. Attracted by the quick fiscal gains they produced, many executives ignored the long-term effects and kept pursuing them well past the time they could be justified.

A turning indicate was the wave of hostile takeovers that swept the country in the 1980s. Corporate raiders often claimed that the complacent leaders of the targeted companies were declining to maximize returns to shareholders. That criticism prompted boards of directors to effort to marshal the interests of management and shareholders past making stock-based pay a much bigger component of executive compensation.

Given incentives to maximize shareholder value and meet Wall Street'south expectations for ever higher quarterly EPS, top executives turned to massive stock repurchases, which helped them "manage" stock prices. The effect: Trillions of dollars that could accept been spent on innovation and job creation in the U.South. economic system over the past three decades take instead been used to buy dorsum shares for what is effectively stock-price manipulation.

Expert Buybacks and Bad

Not all buybacks undermine shared prosperity. There are two major types: tender offers and open-market repurchases. With the former, a company contacts shareholders and offers to buy back their shares at a stipulated cost by a certain near-term date, and so shareholders who detect the price agreeable tender their shares to the company. Tender offers can be a style for executives who have substantial ownership stakes and intendance about a visitor's long-term competitiveness to accept reward of a low stock cost and concentrate ownership in their own hands. This can, among other things, costless them from Wall Street's pressure to maximize short-term profits and let them to invest in the business. Henry Singleton was known for using tender offers in this way at Teledyne in the 1970s, and Warren Buffett for using them at GEICO in the 1980s. (GEICO became wholly owned by Buffett's belongings company, Berkshire Hathaway, in 1996.) Equally Buffett has noted, this kind of tender offer should be fabricated when the share toll is below the intrinsic value of the productive capabilities of the company and the visitor is profitable enough to repurchase the shares without impeding its real investment plans.

But tender offers plant only a small portion of modern buybacks. Most are now washed on the open market, and my enquiry shows that they often come up at the expense of investment in productive capabilities and, consequently, aren't cracking for long-term shareholders.

Companies have been immune to repurchase their shares on the open up market with virtually no regulatory limits since 1982, when the SEC instituted Rule 10b-18 of the Securities Substitution Act. Nether the dominion, a corporation'southward board of directors can authorize senior executives to repurchase up to a certain dollar corporeality of stock over a specified or open-ended menstruum of time, and the company must publicly denote the buyback programme. Later that, management can buy a large number of the company'due south shares on any given business organization day without fear that the SEC volition charge it with stock-price manipulation—provided, among other things, that the amount does not exceed a "rubber harbor" of 25% of the previous four weeks' average daily trading book. The SEC requires companies to report total quarterly repurchases but non daily ones, meaning that it cannot determine whether a company has breached the 25% limit without a special investigation.

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Despite the escalation in buybacks over the by 3 decades, the SEC has just rarely launched proceedings confronting a visitor for using them to manipulate its stock cost. And fifty-fifty within the 25% limit, companies can still make huge purchases: Exxon Mobil, by far the biggest stock repurchaser from 2003 to 2012, can purchase dorsum about $300 million worth of shares a day, and Apple up to $1.five billion a day. In essence, Dominion 10b-18 legalized stock marketplace manipulation through open-market repurchases.

The rule was a major difference from the agency's original mandate, laid out in the Securities Substitution Deed in 1934. The human activity was a reaction to a host of unscrupulous activities that had fueled speculation in the Roaring '20s, leading to the stock market crash of 1929 and the Great Depression. To forestall such shenanigans, the act gave the SEC wide powers to issue rules and regulations.

During the Reagan years, the SEC began to roll back those rules. The commission's chairman from 1981 to 1987 was John Shad, a former vice chairman of Due east.F. Hutton and the first Wall Street insider to lead the commission in l years. He believed that the deregulation of securities markets would aqueduct savings into economic investments more efficiently and that the isolated cases of fraud and manipulation that might go undetected did not justify onerous disclosure requirements for companies. The SEC's adoption of Rule 10b-18 reflected that point of view.

Debunking the Justifications for Buybacks

Executives give three main justifications for open-market repurchases. Let'southward examine them one by i:

1. Buybacks are investments in our undervalued shares that bespeak our confidence in the visitor's hereafter.

This makes some sense. Merely the reality is that over the past ii decades major U.S. companies have tended to practise buybacks in bull markets and cut dorsum on them, often sharply, in deport markets. (See the exhibit "Where Did the Money from Productivity Increases Go?") They buy high and, if they sell at all, sell low. Enquiry by the Bookish-Industry Research Network, a nonprofit I cofounded and pb, shows that companies that do buybacks never resell the shares at college prices.

Buybacks—as well as dividends—accept skyrocketed in the by 20 years. (Note that these data are for the 251 companies that were in the Southward&P 500 in Jan 2013 and were public from 1981 through 2012. Inclusion of firms that went public after 1981, such equally Microsoft, Cisco, Amgen, Oracle, and Dell, would make the increase in buybacks fifty-fifty more marked.) Though executives say they repurchase only undervalued stocks, buybacks increased when the stock marketplace boomed, casting doubt on that claim.

Source: Standard & Poor's Compustat database; the Academic-Industry Research Network.
Annotation: Hateful repurchase and dividend amounts are in 2012 dollars.

Once in a while a company that bought high in a boom has been forced to sell depression in a bust to alleviate fiscal distress. GE, for instance, spent $3.2 billion on buybacks in the first three quarters of 2008, paying an boilerplate price of $31.84 per share. And then, in the final quarter, equally the financial crisis brought nearly losses at GE Capital, the company did a $12 billion stock issue at an average share price of $22.25, in a failed endeavour to protect its triple-A credit rating.

In general, when a visitor buys back shares at what plough out to be loftier prices, it somewhen reduces the value of the stock held by continuing shareholders. "The standing shareholder is penalized by repurchases above intrinsic value," Warren Buffett wrote in his 1999 letter to Berkshire Hathaway shareholders. "Buying dollar bills for $1.x is non good business for those who stick effectually."

2. Buybacks are necessary to offset the dilution of earnings per share when employees exercise stock options.

Calculations that I have done for loftier-tech companies with broad-based stock option programs reveal that the volume of open-market repurchases is generally a multiple of the volume of options that employees exercise. In any instance, there'southward no logical economic rationale for doing repurchases to offset dilution from the exercise of employee stock options. Options are meant to motivate employees to work harder at present to produce higher future returns for the visitor. Therefore, rather than using corporate cash to boost EPS immediately, executives should be willing to expect for the incentive to work. If the company generates college earnings, employees can exercise their options at higher stock prices, and the company tin can allocate the increased earnings to investment in the next round of innovation.

3. Our company is mature and has run out of profitable investment opportunities; therefore, we should return its unneeded greenbacks to shareholders.

Some people used to fence that buybacks were a more than tax-efficient ways of distributing money to shareholders than dividends. Just that has not been the case since 2003, when the tax rates on long-term majuscule gains and qualified dividends were made the same. Much more important bug remain, however: What is the CEO'due south master role and his or her responsibility to shareholders?

Companies that have congenital upwards productive capabilities over long periods typically have huge organizational and financial advantages when they enter related markets. One of the chief functions of top executives is to observe new opportunities for those capabilities. When they opt to do large open-market repurchases instead, it raises the question of whether these executives are doing their jobs.

A related consequence is the notion that the CEO'south main obligation is to shareholders. It's based on a misconception of the shareholders' role in the modernistic corporation. The philosophical justification for giving them all excess corporate profits is that they are best positioned to allocate resources considering they have the virtually involvement in ensuring that capital generates the highest returns. This proposition is central to the "maximizing shareholder value" (MSV) arguments consort over the years, most notably past Michael C. Jensen. The MSV schoolhouse also posits that companies' so-called free cash flow should be distributed to shareholders because only they brand investments without a guaranteed return—and hence bear risk.

Since the early on 1980s, when restrictions on open-marketplace buybacks were profoundly eased, distributions to shareholders accept absorbed a huge portion of net income, leaving much less for reinvestment in companies.

Note: Data are for the 251 companies that were in the S&P 500 Index in January 2013 and were publicly listed from 1981 through 2012. If the companies that went public after 1981, such every bit Microsoft, Cisco, Amgen, Oracle, and Dell, were included, repurchases as a percentage of net income would exist even college.

But the MSV school ignores other participants in the economy who bear risk past investing without a guaranteed return. Taxpayers take on such risk through government agencies that invest in infrastructure and knowledge creation. And workers take information technology on past investing in the development of their capabilities at the firms that employ them. As risk bearers, taxpayers, whose dollars back up business enterprises, and workers, whose efforts generate productivity improvements, have claims on profits that are at to the lowest degree as strong every bit the shareholders'.

The irony of MSV is that public-company shareholders typically never invest in the value-creating capabilities of the company at all. Rather, they invest in outstanding shares in the promise that the stock price volition ascension. And a prime way in which corporate executives fuel that hope is by doing buybacks to dispense the market place. The only money that Apple tree ever raised from public shareholders was $97 million at its IPO in 1980. Nevertheless in recent years, hedge fund activists such as David Einhorn and Carl Icahn—who played absolutely no role in the company'southward success over the decades—have purchased large amounts of Apple stock and then pressured the company to denote some of the largest buyback programs in history.

The past decade'south huge increase in repurchases, in addition to high levels of dividends, have come up at a time when U.S. industrial companies face new competitive challenges. This raises questions most how much of corporate cash flow is really "free" to be distributed to shareholders. Many academics—for example, Gary P. Pisano and Willy C. Shih of Harvard Business School, in their 2009 HBR commodity "Restoring American Competitiveness" and their volume Producing Prosperity—have warned that if U.S. companies don't offset investing much more in research and manufacturing capabilities, they cannot expect to remain competitive in a range of advanced applied science industries.

Retained earnings have always been the foundation for investments in innovation. Executives who subscribe to MSV are thus copping out of their responsibility to invest broadly and deeply in the productive capabilities their organizations need to continually innovate. MSV as usually understood is a theory of value extraction, non value creation.

Executives Are Serving Their Own Interests

As I noted earlier, at that place is a elementary, much more plausible explanation for the increase in open-market place repurchases: the ascent of stock-based pay. Combined with force per unit area from Wall Street, stock-based incentives make senior executives extremely motivated to exercise buybacks on a colossal and systemic scale.

Consider the 10 largest repurchasers, which spent a combined $859 billion on buybacks, an amount equal to 68% of their combined net income, from 2003 through 2012. (Run across the exhibit "The Top x Stock Repurchasers.") During the same decade, their CEOs received, on average, a total of $168 million each in compensation. On average, 34% of their compensation was in the form of stock options and 24% in stock awards. At these companies the adjacent four highest-paid senior executives each received, on average, $77 million in compensation during the ten years—27% of it in stock options and 29% in stock awards. Nevertheless since 2003 simply three of the 10 largest repurchasers—Exxon Mobil, IBM, and Procter & Run a risk—have outperformed the S&P 500 Index.

At most of the leading U.S. companies below, distributions to shareholders were well in excess of net income. These distributions came at great cost to innovation, employment, and—in cases such as oil refining and pharmaceuticals—customers who had to pay higher prices for products.

Sources: Standard & Poor'due south Compustat database; Standard & Poor'due south Execucomp database; the Academic-Industry Research Network.
Note: The percentages of stock-based pay include gains realized from exercising stock options for all years plus, for 2003–2005, the fair value of restricted stock grants or, for 2006–2012, gains realized on vesting of stock awards. Rounding to the nearest billion may bear upon total distributions and percentages of internet income. *Steven Ballmer, Microsoft'south CEO from January 2000 to February 2014, did not receive any stock-based pay. He does, however, own about 4% of Microsoft's shares, valued at more than than $13 billion.

Reforming the Arrangement

Buybacks have become an unhealthy corporate obsession. Shifting corporations back to a retain-and-reinvest regime that promotes stable and equitable growth will accept bold activity. Here are three proposals:

Put an terminate to open up-market buybacks.

In a 2003 update to Dominion 10b-xviii, the SEC explained: "It is not appropriate for the condom harbor to be available when the issuer has a heightened incentive to manipulate its share price." In practice, though, the stock-based pay of the executives who determine to practise repurchases provides merely this "heightened incentive." To correct this glaring problem, the SEC should rescind the safe harbor.

A good beginning step toward that goal would be an extensive SEC written report of the possible damage that open-market place repurchases have done to capital formation, industrial corporations, and the U.S. economy over the past three decades. For example, during that period the amount of stock taken out of the market has exceeded the amount issued in well-nigh every year; from 2004 through 2013 this net withdrawal averaged $316 billion a year. In aggregate, the stock market is non performance as a source of funds for corporate investment. As I've already noted, retained earnings have always provided the base for such investment. I believe that the practise of tying executive compensation to stock price is undermining the formation of physical and human capital letter.

Rein in stock-based pay.

Many studies have shown that big companies tend to use the aforementioned fix of consultants to benchmark executive compensation, and that each consultant recommends that the client pay its CEO well in a higher place average. Every bit a result, compensation inevitably ratchets up over fourth dimension. The studies also evidence that even declines in stock toll increase executive pay: When a company's stock toll falls, the board stuffs fifty-fifty more options and stock awards into top executives' packages, challenge that it must ensure that they won't jump ship and will do whatever is necessary to become the stock price back up.

In 1991 the SEC began allowing top executives to keep the gains from immediately selling stock caused from options. Previously, they had to hold the stock for 6 months or give up whatsoever "curt-swing" gains. That decision has but served to reinforce tiptop executives' overriding personal interest in boosting stock prices. And because corporations aren't required to disclose daily buyback activity, it gives executives the opportunity to merchandise, undetected, on within data about when buybacks are being done. At the very least, the SEC should stop allowing executives to sell stock immediately after options are exercised. Such a rule could aid launch a much-needed discussion of meaningful reform that goes beyond the 2010 Dodd-Frank Act's "Say on Pay"—an ineffectual law that gives shareholders the right to brand nonbinding recommendations to the board on compensation issues.

But overall the use of stock-based pay should exist severely limited. Incentive bounty should exist subject to functioning criteria that reflect investment in innovative capabilities, not stock functioning.

Transform the boards that determine executive compensation.

Boards are currently dominated by other CEOs, who have a stiff bias toward ratifying higher pay packages for their peers. When approving enormous distributions to shareholders and stock-based pay for elevation executives, these directors believe they're acting in the interests of shareholders.

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That's a big part of the problem. The vast majority of shareholders are only investors in outstanding shares who can easily sell their stock when they desire to lock in gains or minimize losses. Every bit I argued earlier, the people who truly invest in the productive capabilities of corporations are taxpayers and workers. Taxpayers have an interest in whether a corporation that uses regime investments can generate profits that allow it to pay taxes, which institute the taxpayers' returns on those investments. Workers take an involvement in whether the company will be able to generate profits with which it can provide pay increases and stable career opportunities.

It's fourth dimension for the U.S. corporate governance system to enter the 21st century: Taxpayers and workers should have seats on boards. Their representatives would have the insights and incentives to ensure that executives allocate resources to investments in capabilities well-nigh likely to generate innovations and value.

Courage in Washington

After the Harvard Law School dean Erwin Griswold published "Are Stock Options Getting out of Manus?" in this mag in 1960, Senator Albert Gore launched a entrada that persuaded Congress to whittle away special tax advantages for executive stock options. After the Tax Reform Act of 1976, the compensation expert Graef Crystal declared that stock options that qualified for the capital-gains revenue enhancement charge per unit, "once the most popular of all executive compensation devices…have been given the last rites by Congress." It as well happens that during the 1970s the share of all U.Southward. income that the pinnacle 0.1% of households got was at its lowest point in the past century.

The members of the U.S. Congress should show the courage and independence of their predecessors and go across "Say on Pay" to practise something about excessive executive compensation. In addition, Congress should prepare a broken tax regime that frequently rewards value extractors as if they were value creators and ignores the disquisitional role of regime investment in the infrastructure and cognition that are so crucial to the competitiveness of U.Southward. business.

Instead, what we take now are corporations that lobby—often successfully—for federal subsidies for research, development, and exploration, while devoting far greater resource to stock buybacks. Here are iii examples of such hypocrisy:

Alternative energy.

Exxon Mobil, while receiving about $600 million a twelvemonth in U.S. government subsidies for oil exploration (according to the Center for American Progress), spends virtually $21 billion a yr on buybacks. Information technology spends virtually no money on alternative energy enquiry.

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Meanwhile, through the American Free energy Innovation Council, acme executives of Microsoft, GE, and other companies accept lobbied the U.Southward. government to triple its investment in alternative energy research and subsidies, to $16 billion a year. Yet these companies had plenty of funds they could have invested in culling free energy on their ain. Over the past decade Microsoft and GE, combined, take spent near that amount annually on buybacks.

Nanotechnology.

Intel executives have long lobbied the U.S. government to increase spending on nanotechnology research. In 2005, Intel's then-CEO, Craig R. Barrett, argued that "it volition take a massive, coordinated U.South. research effort involving academia, industry, and land and federal governments to ensure that America continues to exist the world leader in information technology." Yet from 2001, when the U.S. government launched the National Nanotechnology Initiative (NNI), through 2013 Intel's expenditures on buybacks were almost four times the total NNI upkeep.

Pharmaceutical drugs.

In response to complaints that U.Southward. drug prices are at to the lowest degree twice those in whatsoever other country, Pfizer and other U.South. pharmaceutical companies have argued that the profits from these loftier prices—enabled by a generous intellectual-property regime and lax price regulation—let more R&D to exist done in the United states than elsewhere. All the same from 2003 through 2012, Pfizer funneled an amount equal to 71% of its profits into buybacks, and an amount equal to 75% of its profits into dividends. In other words, information technology spent more on buybacks and dividends than it earned and tapped its capital letter reserves to assistance fund them. The reality is, Americans pay high drug prices then that major pharmaceutical companies can boost their stock prices and pad executive pay.Given the importance of the stock market and corporations to the economy and society, U.S. regulators must footstep in to check the behavior of those who are unable or unwilling to command themselves. "The mission of the U.S. Securities and Exchange Commission," the SEC's website explains, "is to protect investors, maintain fair, orderly, and efficient markets, and facilitate majuscule formation." Notwithstanding, as we take seen, in its rulings on and monitoring of stock buybacks and executive pay over 3 decades, the SEC has taken a class of action contrary to those objectives. It has enabled the wealthiest 0.1% of lodge, including top executives, to capture the lion's share of the gains of U.S. productivity growth while the vast majority of Americans take been left backside. Rule 10b-18, in particular, has facilitated a rigged stock market place that, by permitting the massive distribution of corporate cash to shareholders, has undermined upper-case letter formation, including human uppercase germination.

The corporate resource allocation process is America's source of economic security or insecurity, every bit the case may be. If Americans want an economy in which corporate profits upshot in shared prosperity, the buyback and executive compensation binges volition take to terminate. Every bit with any habit, in that location volition be withdrawal pains. But the best executives may actually get satisfaction out of being paid a reasonable salary for allocating resources in ways that sustain the enterprise, provide college standards of living to the workers who make it succeed, and generate tax revenues for the governments that provide it with crucial inputs.

A version of this article appeared in the September 2014 upshot of Harvard Business organization Review.