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Reforming the Mutual Fund Tax Loophole

March 16, 2009

Important changes to our income tax structure are right around the corner. Increased government borrowing will exert pressure to find additional sources of revenue, and most of this additional revenue will be generated by increasing taxes on individuals. For those of you who have read my previous blog posts or publications, you know that I favor consumption taxes relative to income taxes, but let’s set this aside for the moment and examine one not-so-small, but highly under-publicized, loophole in our current tax system.  That is, the implicit ability to deduct the management fees that mutual funds charge their investors.

By deducting fees from fund assets mutual funds essentially disguise the fees that individual investors pay.  If you hire a money manager, or a financial planner, you cannot deduct the fees that this professional charges you from your investment returns. If you get a 10% return on your money and the money manager charges you a 1% annual management fee you pay taxes on the entire 10%. Because mutual funds deduct fees from assets before calculating return the tax situation is different. If your gross return from a mutual fund is 10% and the mutual fund charges you 1%  annual management fee you pay taxes on the net return — that is 9%.

This is a bigger money issue than it may first appear.  The aggregate net asset value of mutual funds shares held in the U.S. is about $10 trillion.  About half of this amount is held in non-tax-deferred accounts. So, the returns on about $5 trillion is exposed to taxes. The average mutual fund, considering both stock and bond mutual funds, charges about a .90% annual management fee.  That suggests that investors are paying about $45B a year in tax-exempted mutual fund management fees. If the average taxpayer pays a marginal tax rate of 25%, a simplifying but effective assumption given my purpose here, what you have is a little over $11 B that is not flowing into the government coffers that by all rights should be.

Why is this tax break particularly troubling to me?

  1. A tax deduction for money management is massively regressive.  The more money you have, the bigger the tax break you are getting.
  2. It is a loophole that is easily exploited. Wealthy individuals can, and do, pool their money with a reasonably small group of other individuals and legally start “mutual funds.” These funds are not marketed to the general public. They are constructed as legal tax shelters generated in order to allow their limited membership to deduct the cost of money management.
  3. Because no taxes are paid on the fees, many mutual fund shareholders will pay less attention to the fees that they are charged. If fees were made explicit, and taxes paid on the gross rather than the net returns, individuals would undoubtedly pay more attention to the fees charged and many people would be made better off for it.

The forthcoming overhaul of financial regulations should not focus exclusively on institutional transactions, but should grapple with needed changes in the retail market for financial services as well. Informed regulation of the financial markets and revisions in the tax code are inextrcibly intertwined. One focus of good regulation should be to close obvious tax loopholes. What I have written above is one example of a change long overdue.

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