Earlier this month, Senate Finance Committee Chairman Ron Wyden (D-Ore.) released a tax proposal that would significantly limit ETFs’ tax efficiency. While ETFs have benefits beyond taxation, this feature has undoubtedly been a significant factor in the investment vehicle’s exponential growth and popularity.
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Wyden’s rationale was clear: “This particular proposal simply applies the same rules already in place for corporations to regulated investment companies, so wealthy investors can no longer avoid all tax on their gains.”
This is not the first time Sen. Wyden has introduced a proposal meant to target taxation of investments with the goal of reducing wealth inequality. In 2019, he proposed taxing unrealized gains in investment assets every year at ordinary income rates rather than the preferential long-term capital gains rates.
The current proposal takes aim at ETFs’ use of “in kind” transactions, which is at the heart of their tax-efficiency. ETFs create and redeem existing shares with authorized participants through this in-kind process. Current tax law provides that this is not a taxable event.
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Issuers are also allowed to choose which shares they exchange with the authorized participants, allowing them to offload those with the lowest cost basis. This raises the cost basis of the current shares, reducing the fund’s tax burden.
ETF shareholders still pay capital gains tax when they sell funds that have appreciated. Unlike mutual funds, ETF investors are typically only responsible for paying capital gains tax on the appreciation of their own investment.
This stands in contrast to mutual funds that must sell portfolio positions to meet redemptions. In the process, they incur capital gains that are distributed to all shareholders, regardless of whether or not they have sold. This means that mutual fund shareholders may be subject to capital gains even if they have lost money.
This begs the question of why investors should pay for capital appreciation even when they have not been the beneficiary of the increase in value. ETFs’ current tax treatment is arguably a fairer approach, and potentially one that could be extended to mutual funds if legislators wanted to reduce wealth inequality.
Democratization At Risk
The tax proposal threatens the growth of ETFs, which have widely been seen as a tool that democratizes investing. As demonstrated by the wide range of topics on ETF.com, the investment vehicle enables investors to easily access many different parts of the market that were previously unavailable.
Often, the expense ratios are lower than that of comparable mutual funds. In fact, DIY investors can get a diversified portfolio for a fraction of a percent. An ESG portfolio only costs a bit more. Along with low fees, the deferral of capital gains until sale enables investors to build wealth and reach their investment goals faster.
While Wyden’s target is wealth inequality, ETFs’ widespread adoption by people across the wealth spectrum means that all ETF investors will get hurt, regardless of their net worth.
Darren Schuringa, co-founder of Exchange Traded Concepts and current CEO of ASYMmetric ETFs, agrees that this legislation would hurt the small investor: “Look at what ETFs have done for investors in driving down fees. ETFs by their very nature have addressed wealth inequality and leveled the playing field.”
ETFs Will Maintain Advantage
Though tax efficiency is a primary benefit of the ETF wrapper, the vehicle will maintain several advantages over mutual funds even if this proposal is signed into law. Liquidity, transparency and generally lower fees will still be important advantages enjoyed by ETF shareholders.
However, should this proposal be passed, it will have negative consequences for investors’ portfolios, including those that don’t fall into the higher tax brackets. Especially for buy-and-hold investors, paying taxes sooner means there is less money available to grow over time. As a result, small investors in particular will have less of a chance at achieving investment goals and financial security.
Jarrett Lilien, president and COO of WisdomTree, echoed this sentiment: “You’re hurting the retail investor because they’re going to earn less; they’re not going to get the compounding effect of those returns. This is a bill that hurts the end user; it hurts their investment return.”
Ironically, this reduction in future growth also means less tax revenue for the government. Anita Rausch, head of Capital Markets at WisdomTree, added: “You’re going to miss out on the compounding effects of whatever tax you have to pay upfront. The end consumer gets less in return, and the government gets less in taxes.”
If Senator Wyden’s goal is to reduce wealth inequality, this proposal will only hurt the people he is intending to help.