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Not this time
Taxes on investments don’t bother me. If I criticize a suggestion to increase taxes on investments, my opposition is practical rather than ideological. That is to say, I am challenging the measure not because of its political orientation, but because it is ill-conceived. There are better ways for government to raise money.
In that vein: I challenge the bill that was submitted earlier this month by Senate Finance Committee Chairman Ron Wyden that would change the way exchange-traded funds are taxed. The objective of the proposal is laudable. Currently, ETFs are taxed more favorably than mutual funds. President Wyden’s disposition would ensure equality. It’s a good goal. Unfortunately, treating ETFs like mutual funds is going in the wrong direction. Better to do the reverse.
The backdrop
In theory, mutual funds and ETFs are interchangeable. Both vehicles are governed by the 1940 Investment Law, which ensures that they have the same investment restrictions and accounting conventions. Their performance is directly comparable. Mutual funds and ETFs are so similar that Morningstar considers them one and the same when assigning star ratings.
However, due to technicality, ETF shareholders pay lower capital gains taxes. The 1940 law requires funds to distribute substantially all of their annual net realized capital gains, creating a taxable event for shareholders. So far so fair. But because mutual funds sometimes have to sell their portfolio holdings to raise funds for investors who redeem their stocks, while ETFs can avoid doing so by using “creation units” (whatever the details) , mutual funds tend to generate higher tax burdens.
This gives ETFs an unfair advantage. It’s one thing for ETFs to take market share from mutual funds by being the best mousetrap. Being publicly traded makes ETFs more accessible than mutual funds. For this reason, I predicted that ETFs will become the dominant investment in the country. Its good; they deserve the honor. But it is quite another thing to be given a legislative advantage.
So, as Morningstar’s Aron Szapiro wrote two years ago, it makes sense to eliminate the regulatory difference between ETFs and mutual funds. But not that way. Rather than forcing ETF investors to pay more capital gains taxes, Congress should allow mutual fund shareholders to pay less, or more precisely, none. Neither mutual funds nor ETFs should distribute their realized capital gains. Instead, these funds should remain in the fund until the shareholder sells.
Less is more
One of the reasons not to force funds to distribute their capital gains is simplicity. Certainly, the calculation of the amount of the distribution of capital gains is simple. It costs fund companies very little. In addition, to my knowledge, a fund company has never incorrectly notified its shareholders’ tax obligations. The settlement does not cause legal problems.
Yet a bigger tax code is a bigger tax code: a boon to TurboTax, a curse for taxpayers. Also, while fund companies know when their funds have realized capital gains and will therefore be making expensive distributions; investors don’t. Through the preparatory work, shareholders of the fund may be able to be informed in advance of the upcoming distribution of a fund by contacting the fund company directly or by researching the information provided by my colleague Christine Benz. But this process is hardly ideal.
The requirement does not yield much benefit to the US Treasury. In recent years, mutual funds have paid out around $ 400 billion a year in capital gains distributions, which would represent nearly $ 100 billion in tax revenue to the treasury if all stocks were in taxable accounts and at the highest tax rates. However, neither of the two hypotheses holds. In addition, capital gains taxes paid today are not paid tomorrow. Insisting that mutual funds distribute their realized gains returns the same money to the treasury sooner. It doesn’t earn him more money.
Strange and Unusual
Another problem with the current tax structure is that it favors stocks over mutual funds. If I own Berkshire Hathaway’s B shares (BRK.B) in a taxable account, I pay no tax. The company does not distribute any dividend and does not distribute any capital gain. However, if I bought Berkshire Hathaway through a mutual fund that only owned that company and the fund sold Berkshire Hathaway shares to meet redemption requests, I may well receive a distribution of earnings. in capital.
It is legally irregular. In each case, I would own the same underlying, which would function identically (except for the fund’s expenses, which shouldn’t be significant, given that it only owns one security). However, the stock would not generate any tax liability, while the fund owning the stock would offer its taxable investors lower returns. It’s particular.
Finally, the way the United States taxes mutual funds is unusual. Morningstar’s voluminous report, “Global Investor Experience Study: Regulation and Taxation,” notes that the United States is among the few countries that tax gains made by mutual funds. The authors note that this not only disadvantages mutual funds over ETFs and stocks, but also disadvantages active managers. “In summary,” the authors state, “the US tax system is confusing to investors and makes active open-ended mutual funds much less attractive than they would otherwise be.”
Even staunch supporters of American exceptionalism might turn pale in this matter.
Plan B
Of course, in making his proposal, Senator Wyden hoped to increase federal revenues, whereas I have just advocated reducing them. How to square this circle?
An idea: Adopt a tax on financial transactions. I will not go into this idea, which I have discussed before, but I will note that 1) Jack Bogle supported it wholeheartedly, 2) such a tax would generate substantial revenue, at least equivalent to that foregone from the taxation of capital gains realized on mutual funds; and 3) it would penalize fast trading institutions, unlike the current system, which penalizes retail buy-and-hold investors.
Certainly, putting in place a tax on financial transactions would violate my first principle, which was to seek simplicity. One suggestion that preserves the principle is to increase the income tax rate for the upper brackets by a single percentage point. This would generously compensate for lost mutual fund revenue without fattening the tax code.
Finally, the government could be satisfied with a little less revenue. A radical concept, I know.
John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar generally agrees with the opinions of the Rekenthaler Report, his opinions are his.
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