A Fresh Call to Right a Tax Wrong

Politicians fight like heck to be seen as champions of the middle class but somehow never show much interest in the mutual fund tax penalty. My guess is they want to sound like champions, but many are such products of old money that they don't know much at all about mutual funds--let alone the tax penalty.

The current rule requires that fundholders pay taxes whenever their funds realize gains and distribute to them. And funds are required to distribute nearly all the gains they realize in a given year. This means fundholders receive a pile of distribution forms in an up year for the market and have to pay a tax bill even if they've lost money on their investments. See what taxpayers had to do in April 2008 for an example.

So, it was refreshing to hear suggestions made to Congress that they remove the penalty. The Committee on Capital Markets Regulation, a non-partisan think tank, released a report by Harvard Law Professor John C. Coates that suggests that investors shouldn't have to pay taxes on funds until they sell them. Specifically, he says this should apply to all who own less than 2% of a fund's total shares.

"I was struck as an investor as much as an academic by how unfair the process is, especially for middle-class people," the Wall Street Journal quoted Coates as saying. "We've set up a system that punishes people who can't afford to invest in hedge funds."

This change would put funds on par with stocks. As it is, when a fund realizes capital gains, fundholders are taxed on those gains regardless of whether they hold the fund at a gain or loss. It's an awfully random way to figure out if an investor has made a profit. After all, we don't tax shareholders of a stock every time the company reports a profit.

Coates makes another point that I hadn't thought as much about: He argues that the tax penalty hurts the ability of U.S. fund companies to compete with foreign ones because it prevents foreign citizens from investing in U.S. funds. I'd add that if you could draw more money into U.S. funds you might get lower expense ratios, something that would be an additional benefit to fund investors.

The current unwieldy system has several other negative side effects.

� It harms fundholders' long-term aftertax returns by forcing them to pay taxes earlier in the process. Otherwise that money would be growing in their funds and they would have a higher aftertax return over the life of their investment.

� The reams of paperwork around fund tax distributions mean more time and money spent by investors and their accountants in computing taxes.

� By forcing fundholders to pay as they go on taxes, the system increases the likelihood that they will swap into another fund because there's no tax consequence or in order to avoid a distribution that's greater than their profit in the fund. This creates needless frictional costs and encourages short-term behavior that inevitably leads to lower returns.

� It puts fundholders at a disadvantage to stockholders.

Maybe now is the perfect time to finally eliminate the penalty as last year's bear market has left funds with large negative gains built up. That means it won't have much impact on Treasury revenues in the short run.

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