ICI: Transaction tax would take big bite out of fund returns

High on the mutual fund industry's “to do” list is defeating legislation that would impose a $150 billion-per-year tax on securities transactions.

High on the mutual fund industry’s “to do” list is defeating legislation that would impose a $150 billion-per-year tax on securities transactions.

While the legislation, introduced Dec. 3 by Rep. Peter DeFazio, D-Ore., and 27 other Democrats in the House, specifically exempts mutual fund share transactions, Paul Schott Stevens, president and chief executive of the Investment Company Institute, said it would reduce fund shareholder returns substantially.

“No matter how you orchestrate this tax, the likelihood is that average investors are going to pay it,” he said. “The mutual fund, on your behalf, is buying stocks and other securities, and it would have to pay the tax. So you will be hit as a fund investor for your share of the tax on the fund’s own portfolio securities transactions.”

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The bill would impose a 0.25% tax on stock transactions and a 0.2% tax on futures contracts, swaps, credit default swaps and options.

Sen. Tom Harkin, D-Iowa, introduced similar legislation Dec. 23, co-sponsored by Bernie Sanders, Ind.-Vt., Sheldon Whitehouse, D-R.I., and Sherrod Brown, D-Ohio. That bill now goes to the Senate Banking Committee for consideration.

A spokeswoman for Mr. Harkin said he worked closely with Rep. DeFazio in drafting the legislation.

Under the bills, trades made for tax-favored retirement accounts, Section 529 college savings accounts and health savings accounts also would be exempt from the tax, along with the first $100,000 in annual stock transactions.

If the tax had been in effect in 2008, when $6.7 trillion in fund trades took place, it would have cost equity mutual fund shareholders $8.4 billion, according to ICI estimates. That year, $133 billion in capital gains was distributed to shareholders in all funds, ICI said.

“Industry estimates on this tax have historically been exaggerated,” Molly Simmons, a spokeswoman for Mr. DeFazio, wrote in an e-mail. From 1914 to 1966, the U.S. imposed a transfer tax of between 0.2% and 0.4% on stock transactions, during which time the Dow Jones Industrial Average rose from 60 to nearly 1,000, she noted.

The ICI’s estimate is conservative, said Gus Sauter, chief investment officer of The Vanguard Group Inc.

He estimated that the tax would add about $20 billion in direct costs and an additional $50 billion in wider bid-offer spreads. “Transaction costs will widen back out again as market makers step back out from the marketplace,” Mr. Sauter said. That $70 billion in total costs could reduce fund returns to shareholders to 8% per year instead of the historical return of about 10% per year, he said.

‘CHANGES CAN BE MADE’

The bill’s proponents say concerns about the effect on mutual fund shareholders can be addressed as the legislation is considered. “Amendments and changes can be made, and we’re certainly going to look at that,” said Leslie Oliver, a spokeswoman for Rep. Ed Perlmutter, D-Colo., one of the sponsors of the legislation.

Another supporter of the legislation, Damon Silvers, policy director at the AFL-CIO, argues that the tax would encourage long-term investment while discouraging what he called “churning” of stock trades. Investors in buy-and-hold index funds would pay far less as a result of the tax than investors in actively managed funds, he said. “This would be a disincentive to invest in strategies that the public often puts their money in, but experts know don’t often work,” he said, referring to actively managed funds.

The tax is estimated to have the potential to raise substantial sums at a time that the federal budget deficit is projected to be $1.4 trillion for the fiscal year that began Oct. 1, Mr. Stevens noted.

Most investors do not understand the effect the tax could have on capital markets, he said, adding that the bill is expected to be a major focus for the ICI this year.

Mr. Stevens noted that the likelihood of the bill’s success will depend on the political climate. “I do not underestimate the ire that people have at Wall Street firms that, fairly or not, they blame for our financial predicament,” he said.

While Treasury Secretary Timothy Geithner has criticized the tax, House Speaker Nancy Pelosi, D-Calif., commented at a news conference when the tax was introduced that it “has a great deal of merit.”

To keep investors from fleeing U.S. markets, she suggested that the United States coordinate with other developed nations to impose a similar tax. U.K. Prime Minister Gordon Brown also has called for developed countries to impose a uniform securities transaction tax.

The Securities Industry and Financial Markets Association and the Financial Services Institute Inc. have come out against the proposal.

SIFMA’S RESPONSE

The transaction tax “is the wrong policy at the wrong time” and would undermine economic recovery and job creation, SIFMA executive vice president Ken Bentsen said in a release.

The proposal “would have serious unintended negative consequences for independent broker-dealers, independent financial advisers and the middle-class clients they serve,” the FSI said in a report to its members.

The U.S. Chamber of Commerce is also fighting the tax proposal. “It’s sold as taxing rich Wall Street guys and raising a ton of money to help with our deficits,” said David Hirschmann, president and chief executive of the chamber’s Center for Capital Markets Competitiveness. “But in reality, it does neither, because Wall Street would pass the cost on to average investors, and it wouldn’t bring in the [expected] revenue,” he said.

Even mutual fund industry critic Mercer Bullard agrees that the transaction tax would hit fund shareholders. “If this is intended to be a Wall Street tax, it’s anything but,” said Mr. Bullard, founder and president of Fund Democracy Inc. “It is structured as a Main Street tax because it would hit mutual fund investors.”

The Financial Planning Association is still studying the issue, said Phillips Hinch, assistant director for government relations. “There’s been a lot of concern about high-frequency computer trading and how the transactions happen so fast that the end-consumer is paying the price for that,” he said. “We haven’t come to a conclusion one way or another.”

E-mail Sara Hansard at [email protected].