Firms that buy back stock tend to reduce the number of shares outstanding and therefore increase earnings per share and, thus, share prices. Hence, stock buybacks tend to create capital gains. Even when dividends and capital gains are taxed at the same rate, capital-gains taxes can be deferred until the stocks are sold, or even avoided completely if the shares are later bequeathed. Thus, managers acting in the interest of the shareholder will prefer to engage in buybacks rather than increasing dividends.
