November 18, 2009

Impact of a Securities Transaction Tax on Fund Investors

  • A transaction tax imposed on purchases and sales of securities would substantially reduce the investment returns of the nearly 90 million shareholders invested in registered investment companies (mutual funds, ETFs, and closed-end funds).
  • This proposed tax could greatly harm individual fund investors, subjecting them to double taxation.
    • First, the tax could apply to individuals buying and selling shares of their funds. It would penalize individuals for normal activities such as, for example, periodically rebalancing their portfolios, selling fund shares to make purchases or pay taxes, reinvesting distributions from dividend and capital gains, and moving assets from a 401(k) to an IRA.
    • Second, the tax would reduce the value of fund shares held by individuals. Mutual funds routinely buy and sell securities to invest shareholder cash flows, obtain cash to meet investor redemptions, and adjust fund portfolios. When a fund buys and sells securities a transaction tax would increase the cost of those trades and reduce the return on the fund. For example, such a tax could increase the cost of buying and selling stocks by 25 to 60 percent1 for all investors, such as mutual funds, defined benefit pension plans, state and local investment pools, and collective investment trusts.
  • Had such a tax been in place in 2008, mutual fund shareholders in stock, bond, and hybrid funds would have had their returns reduced by $48 billion
    • Mutual fund shareholders purchased and sold over $5 trillion in shares of stock, bond, and hybrid mutual funds in 2008. A tax of 25 basis points on these transactions would have reduced shareholder wealth by $13 billion.
    • Stock, bond, and hybrid mutual funds themselves purchased and sold about $14 trillion in common stocks and other securities in 2008. A financial transaction tax imposed on portfolio purchases and sales would have reduced mutual fund shareholder assets by $35 billion, equal to a reduction in fund returns of 40 basis points.
    • Mutual fund shareholders reinvested $277 billion of paid capital gain and dividend distributions back into stock, bond and hybrid funds in 2008, which would translate into a tax of roughly $690 million.
  • Such a tax would affect active and index funds alike. Investors in index funds buy and sell fund shares, and index funds also buy and sell securities.
    • In 2008, for example, investors in index funds bought and sold $466 billion of fund shares, and index mutual funds purchased and sold nearly $540 billion of common stocks and other securities. A transaction tax would reduce index fund returns by 30 basis points.
  • If applied to money market funds, the proposed tax would severely damage the industry. Many shareholders, particularly businesses, use money market funds as transaction accounts.
    • In 2008, money market fund shareholders purchased and sold nearly $48 trillion in shares—almost 14 times the average level of total net assets for the industry in the year. Shareholders would face an additional expense of $120 billion just to use money market funds.
    • Money market fund investors would seek out a non-taxed alternative, either domestically or overseas, to a money market fund, especially in the low interest rate environment we are currently experiencing. This would result in a significant reduction in the supply of short-term credit to corporate America unless banks raised substantial amounts of capital to be able to support their expanded balance sheets.
    • Even with an exemption for money market fund shareholder transactions, the future of the money market fund industry would still be at risk. A transaction tax on these investment activities could conceivably cost more than the interest earned on the securities, particularly if the tax were paid on every single overnight repurchase agreement.
  • The proposed tax would make financial markets less efficient by reducing market volumes, thereby impairing liquidity and distorting price discovery. As with any new tax or regulation, market participants will seek to minimize its impact through various mechanisms, such as a change in their behavior.
    • One unintended consequence of such a tax would be that trading would migrate to venues that are less costly, i.e., that are not subject or less subject to the tax, particularly to the overseas markets. Major trading firms would alter their systems to accommodate the demand for trading on the country’s tax-free exchange.
    • Similarly, any country that offered tax-free trading could become a major financial center as U.S. companies would have incentive to delist in the U.S. and re-list on the tax-free country’s exchange.
  • If trading could not move to a less-taxed alternative venue, another unintended consequence of this tax is that raising new funds would be more expensive for U.S. firms. Consequently, there would be a negative effect on capital investment.
    • This tax would raise the hurdle rate (the required rate of return in a discounted cash flow analysis above which the investment is profitable and below which it is not) for corporate projects that would add value to the company’s bottom line. As a consequence, a higher hurdle rate would lower the number of profitable projects and reduce investment.
    • The hurdle rate increases because investors would demand a higher expected rate of return on the project to compensate them for the additional tax they would have to pay to purchase the company’s securities.

1 Calculation assumes proposed tax rate 25 basis points on any one-way (purchase or sell) transaction.