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ICI Research and Background on Transaction Tax

Recent proposals to exempt middle-class investors from a proposed transaction tax (H.R. 4191) do not work – mutual fund investors still would be taxed.

  • A recent legislative proposal (H.R. 4191) would impose a new tax on securities transactions, but attempts to shelter middle-class investors from the effects of a transaction tax in two ways:
    • Exempting purchases and sales of mutual fund shares from the tax, and
    • Exempting from tax (directly or via offsetting tax credits) pensions, retirement accounts, and transactions by individual investors (up to $100,000 per year).
  • Neither of these provisions can effectively shelter individual mutual fund investors from the tax.
    • While an investor would not be taxed for buying shares in mutual funds, the funds’ stock transactions on their investors’ behalf would still be taxed—reducing investor returns.
    • The bill as drafted does not allow mutual fund investors to claim tax credits to offset the transaction tax imposed on funds’ portfolio transactions.
    • Efforts to create such credits for mutual fund investors would be unworkable and would probably cost investors more than the credits are worth.
    • All market participants are affected by the market distortions that a transaction tax would create. The proposed tax would make financial markets less efficient by reducing market volumes, impairing liquidity, and distorting price discovery.

A securities transaction tax would be a tax on all investors, not just short-term investors

  • Mutual funds buy and sell securities at the portfolio level to invest shareholder cash flows, obtain cash to meet investor redemptions, and adjust fund portfolios. A transaction tax at the portfolio level would increase the costs of these necessary transactions, reducing the rate of return earned by fund investors.
    • A transaction tax would reduce returns for actively managed funds and index funds alike. In 2008, for example, equity index mutual funds purchased and sold nearly $283 billion of common stocks and preferred stocks.
    • A 25 basis point transaction tax on these transactions would have reduced equity index fund returns by 5 basis points.
    • Although a seemingly small reduction, the asset-weighted average expense ratio for S&P 500 index funds is 15 basis points. Thus, for equity index funds, the securities transaction tax would be equivalent to an increase in fund expenses of one-third.

Efforts to shield middle-class mutual fund investors from the effects of the securities transaction tax would likely cost these investors more than the refund itself

  • H.R. 4191 would tax the securities transactions that mutual funds conduct in their portfolios on their investors’ behalf.
  • As drafted, the bill does not provide a statutory “flow through” mechanism so that mutual fund shareholders can claim credit for those taxes paid on fund portfolio transactions. Even if it was decided to extend these benefits to mutual fund investors for tax paid on portfolio-level transactions the costs of developing a system that could assist these investors in receiving a credit for their share of the taxes paid by the fund could outweigh the value of the tax credit for these investors.

To extend the benefits of the exclusions and credits to mutual fund investors, mutual funds would need to calculate transaction taxes paid on a daily basis on portfolio securities, and create systems to capture and distribute this information to transfer agents and intermediaries that track the ownership of shares on a daily basis. This is needed in order for fund recordkeepers and intermediaries to calculate the transaction taxes paid on a daily basis as it applies to each beneficial owner of mutual fund shares (whose share balances may vary as frequently as daily). Systems and repositories will need to be built by fund transfer agents and intermediaries to capture, calculate and track such taxes paid in addition to providing information reporting to the owner of record each calendar year end.

  • Currently no such systems exist for mutual fund portfolio accounting, fund transfer agents or intermediary recordkeepers to capture, distribute, calculate, retain and report such information to owners of funds. Funds, intermediaries and their service providers currently have no business rationale to build such infrastructure and systems.
  • Building the infrastructure and ancillary recordkeeping systems to track and report all of the necessary information would be difficult and costly for mutual funds and intermediaries (including broker/dealers, clearing firms, banks, trust companies, recordkeepers, financial advisors, and insurance companies) that would be responsible for tax reporting such information to owners of fund shares.
  • The cost of building and maintaining such infrastructures, including the ancillary record keeping systems and reporting structures, would be reflected in lower investment returns for mutual fund shareholders.
    • These costs could outweigh any potential tax benefits for investors eligible for the special exemptions and would provide no value to investors ineligible for the special exemptions.
  • The sole purpose of such a system would be to try to shield a portion of investors from the burden of the new tax.
  • Regardless of intent, current legislative proposals do not exempt middle-class mutual fund investors from the tax. And, it is unlikely that a cost-effective and administrable system could be devised that would protect middle-class mutual fund investors from paying this tax.

A transaction tax could be difficult to avoid or easy to administer, but it is unlikely to be both

  • Some proponents of the tax note that a securities transactions tax already exists in the US to fund the SEC. But the taxes being contemplated have a rate nearly 200 times higher than the current tax and cover a broader range of securities.
  • Given the rates of transaction taxes being contemplated in current policy discussions, the incentive to avoid the tax will be of a completely different magnitude.
  • The tax could be avoided by simply not trading. Indeed, one of the rationales for the tax is that it would reduce trading.
  • However, the tax can also be avoided by changing the venue of the trade or the nature of the securities traded.
  • For example, if transaction tax rates as are not uniform globally, trading will migrate to markets with lower taxes.
    • Sweden implemented a transaction tax in 1984. By 1990, 50 percent of all trading in Swedish equities had migrated offshore.
    • A transaction tax could erode the position of the US as the preeminent world financial center.
  • Instead of reducing the amount of resources engaged in financial engineering, a transaction tax is likely to spawn a new industry focused on devising new ways to avoid the tax.
    • There are ways to replicate long holdings in stocks using bonds and options that will reduce taxes even if options are taxed at the same rate.
    • If debt instruments are exempt, there will also be incentives to produce bonds that replicate the returns of a stock or stock portfolio. In fact, this has already been done with exchanged traded notes (ETNs).
  • To minimize avoidance, the base of the transaction tax would need to be as broad as possible. However, broadening the base would make the tax harder to administer.
    • To discourage transactions from moving off shore, both transaction tax rates and tax compliance would need to be coordinated internationally.
    • Enforcing the tax on private (off-exchange) transactions would require much more reporting than currently occurs.
    • Similarly, there is no system that tracks exchanges in non-registered securities.

In addition to the direct costs of the tax, the tax is likely to have negative effects on all investors in the market and the broader economy

  • The tax would impair liquidity and price discovery.
    • Proponents of the tax suggest, because US markets are very liquid, any decline in volume due to the tax would not hurt the performance of the market.
    • Although this may be true for some securities, there are some securities, such as mid-cap and small cap stocks, that would be adversely affected.
    • All market participants benefit from prices that reflect all available information about a firm.
  • All investors would be hurt by a transaction tax because reduced liquidity will increase bid-ask spreads, make markets less efficient by reducing market volumes, and distort price discovery.
  • By exempting debt securities, the tax would be one more aspect of the tax system that would encourage firms to use debt finance rather than equity finance.
    • The current income tax already favors debt financing over equity financing; the proposed tax would exacerbate that tendency.
    • Companies that are more highly leveraged are more sensitive to economic downturns.