Congress' Proposal for ETF Tax Reform: Good Idea, Bad Execution

Not This Time

Investment taxes don’t bother me. If I criticize a suggestion to increase investment taxes, my opposition is practical rather than ideological. That is, I dispute the measure not because of its political slant, but because it is ill-conceived. There are better ways for the government to raise money.

In that vein: I dispute the draft legislation that was submitted earlier this month by Senate Finance Committee Chairman Ron Wyden, which would change how exchange-traded funds are taxed. The aim of the proposal is laudable. Currently, ETFs are taxed more favorably than are mutual funds. Chairman Wyden's provision would ensure equality. That is a sound goal. Unfortunately, treating ETFs like mutual funds heads 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 Investment Act of 1940, which ensures that they possess the same investment restrictions and accounting conventions. Their performances are directly comparable. Mutual funds and ETFs are so similar that Morningstar considers them to be one and the same when assigning star ratings.

However, because of a technicality, ETFs shareholders pay lower capital gains taxes. The 1940 Act mandates that funds distribute substantially all their annual net realized capital gains, thereby creating a taxable event for shareholders. So far, so fair. But because mutual funds must sometimes sell their portfolio holdings to raise cash for investors who redeem their shares, while ETFs can avoid doing so by using "creation units" (never mind the details), mutual funds tend to generate higher tax bills.

That gives ETFs an unfair edge. It’s one thing for ETFs to take market share from mutual funds by being the better mousetrap. Being listed on an exchange makes ETFs more accessible than mutual funds. For that reason, I have predicted that ETFs will become the nation’s dominant investment. That is fine; they deserve the honor. But it is quite another thing to be gifted a legislative advantage.

Thus, as Morningstar’s Aron Szapiro wrote two years ago, it does make sense to eliminate the regulatory difference between ETFs and mutual funds. But not this way. Rather than make ETF investors pay more capital gains taxes, Congress should permit mutual fund shareholders to pay fewer--or more precisely, none. Neither mutual funds nor ETFs should distribute their realized capital gains. Instead, those monies should remain with the fund until the shareholder sells.

Less Is More

One reason for not forcing funds to distribute their capital gains is simplicity. True, computing the amount of the capital gains distribution is straightforward. Doing so costs fund companies very little. Also, to my knowledge, a fund company has never meaningfully misstated its shareholders’ tax liabilities. The regulation does not lead to legal problems.

Still, a fatter tax code is a fatter tax code: a boon for TurboTax, a curse for taxpayers. What’s more, while fund companies know when their funds have realized capital gains, and therefore will be making costly distributions; investors do not. Through legwork, fund shareholders may be able to receive advance word about a fund’s upcoming distribution by contacting the fund company directly, or by tracking down information provided by my colleague Christine Benz. But that process is scarcely ideal.

The requirement doesn't yield much benefit for the United States Treasury. In recent years, mutual funds have paid about $400 billion per year in capital gains distributions, which would amount to nearly $100 billion in tax receipts for the Treasury if all shares were in taxable accounts and at the highest tax rates. However, neither assumption holds. In addition, capital gains taxes paid today are not paid tomorrow. Insisting that mutual funds distribute their realized gains brings the Treasury the same money earlier. It does not bring it more money.

Strange and Unusual

Another problem with the current tax structure is that it privileges stocks over mutual funds. If I hold B shares of Berkshire Hathaway’s BRK.B in a taxable account, I pay no tax whatsoever. The company issues no dividend and distributes no capital gains. However, were I to buy Berkshire Hathaway through a mutual fund that owned only that company, and the fund sold Berkshire Hathaway shares to meet redemption requests, I might well receive a capital gains distribution.

That is regulatorily irregular. In each case, I would own the same underlying asset, which would perform identically (save for the fund’s expenses, which shouldn’t be much, given that it holds but a single security). However, the stock would generate no tax liability, while the fund that owned the stock would provide its taxable investors with lower returns. That is … peculiar.

Finally, how the U.S. taxes mutual funds is unusual. The voluminous Morningstar report, "Global Investor Experience Study: Regulation and Taxation" notes that the U.S. is among the few countries to tax mutual funds' realized gains. The authors note that doing so not only places mutual funds at a disadvantage to ETFs and stocks, but also handicaps active managers. "In sum," the authors state, "the United States' tax system is confusing for investors and makes active open-end mutual funds much less attractive than they would otherwise be."

Even fervent supporters of American exceptionalism might blanch at this case.

Plan B

Of course, in making his proposal, Senator Wyden hoped to increase federal revenues, while I have just advocated reducing them. How to square that circle?

One idea: Adopt a financial transaction tax. I will not belabor this idea, which I have previously discussed, but I will note that 1) Jack Bogle heartily supported it, 2) such a tax would generate substantial receipts, at least matching that forgone from taxing realized mutual fund capital gains, and 3) it would penalize fast-trading institutions, as opposed to the current system, which hurts buy-and-hold retail investors.

Admittedly, implementing a financial transaction tax would violate my first tenet, which was to seek simplicity. A suggestion that preserves the tenet is to increase the income-tax rate for higher brackets by a single percentage point. Doing so would handsomely compensate for the lost mutual fund receipts while not fattening the tax code.

Finally, the government could make do with slightly less revenue. A radical concept, I know.

John Rekenthaler (john.rekenthaler@morningstar.com) 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 typically agrees with the views of the Rekenthaler Report, his views are his own.