The Generating Retirement Ownership Through Long-Term Holding (GROWTH) Act: A Deep Dive into Proposed Investment Tax Reform

The tax treatment of investment income stands as a critical determinant of the United States’ long-term economic trajectory, directly influencing the after-tax returns available to savers and shaping the investment decisions of American households. Current tax regulations, particularly those governing capital gains, have been identified as potential barriers to domestic investment and are often criticized for creating inconsistencies that can disadvantage certain investment vehicles over others. In response to these concerns, Senator John Cornyn (R-TX) and Representative Beth Van Duyne (R-TX) have introduced the Generating Retirement Ownership Through Long-Term Holding (GROWTH) Act in both chambers of Congress during the current legislative session. This bipartisan proposal aims to harmonize the tax treatment of investment funds and enhance the incentives for saving by allowing investors to defer capital gains taxes on qualifying reinvested distributions until they ultimately sell their fund shares.

Understanding the Current Landscape: Tax Disparities in Investment Funds

At the heart of the GROWTH Act’s rationale lies a fundamental disparity in how capital gains are taxed between conventional mutual funds and exchange-traded funds (ETFs), even when these funds hold virtually identical underlying portfolios. Both types of funds are classified as regulated investment companies (RICs) and are generally subject to similar overarching tax rules. However, their distinct operational mechanisms, particularly concerning shareholder redemptions, lead to markedly different tax outcomes for investors.

A capital gains tax is a levy on the profit derived from selling an asset, often in addition to corporate income taxes, which can lead to double taxation. Such taxes are frequently cited by economists as creating a bias against saving, as they reduce the net return on investment, thereby encouraging present consumption over long-term capital formation and potentially leading to a lower level of national income. The nuances of how these taxes are applied across different investment vehicles exacerbate this issue, creating what is known as horizontal inequity – where similarly situated investors face different tax burdens.

Consider a traditional mutual fund, a pooled investment vehicle managed by a professional fund manager. When a shareholder decides to redeem their shares, the fund typically needs to sell a portion of its underlying securities to generate the cash required to pay out the departing investor. For instance, if a mutual fund holds a stock acquired at $20 that has appreciated to $100, and a shareholder redeems $100 worth of fund shares, the fund may sell $100 of that stock, realizing an $80 capital gain. Under current law, this realized net capital gain is then distributed to all remaining fund shareholders, not just the one who redeemed their shares. Consequently, the remaining shareholders become liable for capital gains tax on these distributions, even though they have not sold any of their own mutual fund shares and may not have intended to realize any gains. This phenomenon, often referred to as "phantom income" or "tax drag," means mutual fund investors can incur tax liabilities while still holding their positions, diminishing their overall after-tax returns. Data from the Investment Company Institute (ICI) consistently show that mutual funds tend to have significantly higher average capital gains distributions compared to ETFs, underscoring this practical difference. For example, research published in the Review of Financial Studies has quantified this disparity, highlighting the measurable impact on investor returns.

In contrast, exchange-traded funds (ETFs) operate with a different redemption mechanism that largely circumvents this issue. Retail ETF shareholders typically buy and sell their shares on secondary markets, much like individual stocks, rather than directly redeeming them from the fund itself. When large blocks of ETF shares are redeemed from the fund, this process is primarily handled by "authorized participants" (APs). These APs typically exchange blocks of ETF shares for a corresponding basket of the fund’s underlying securities, rather than cash. Crucially, these "in-kind" redemptions generally do not trigger the realization of capital gains within the fund. This means that remaining ETF shareholders are shielded from capital gains distributions that would otherwise be passed on to them, leading to a more tax-efficient investment experience during the holding period. Investors in both fund types must eventually pay capital gains tax upon the sale of their own fund shares, but the timing of tax liability for mutual fund holders can be significantly earlier and more frequent.

This operational divergence creates a situation where an investor could theoretically hold an identical portfolio of securities and achieve the same gross investment return, yet face materially different current tax liabilities solely based on whether they chose a mutual fund or an ETF structure. From a principle of tax neutrality, where investment decisions should be driven by economic merit rather than tax implications, this discrepancy represents a significant distortion in the tax code. The objective of sound tax policy is to minimize such distortions, allowing capital to flow to its most productive uses without being swayed by arbitrary tax rules.

The Genesis of the GROWTH Act: A Legislative Response

The GROWTH Act emerges from a recognition of these structural tax inefficiencies and their potential to hinder long-term savings and investment. Senator John Cornyn, a senior member of the Senate Finance Committee, and Representative Beth Van Duyne, a member of the House Ways and Means Committee, have positioned the bill as a targeted reform designed to foster greater equity and simplicity in investment taxation. While specific dates of introduction can vary with legislative cycles, the proposal has been brought forward "this session," indicating a recent legislative push to address these long-standing issues. The sponsors have emphasized the act’s role in promoting retirement ownership and encouraging long-term holding, aligning with broader goals of enhancing individual financial security.

The core mechanism of the GROWTH Act is straightforward yet impactful: it would permit investors to defer the recognition of capital gains tax on qualifying reinvested distributions until they ultimately sell their fund shares. This means that if an investor receives a capital gains distribution from a mutual fund and chooses to reinvest that amount back into the fund, they would not owe tax on that gain until they liquidate their position. It is important to note that the deferral applies specifically to capital gains distributions that are reinvested. Dividend and interest income generated by the fund would continue to be taxed as under current law, ensuring that other forms of investment income maintain their existing tax treatment.

By aligning the tax timing for reinvested capital gains in mutual funds more closely with the inherent tax efficiency of ETFs, the GROWTH Act seeks to level the playing field. This aims to remove a significant disincentive for investors to choose mutual funds for long-term holding, allowing them to make investment decisions based purely on a fund’s performance, fees, and investment strategy, rather than its tax structure. This move is consistent with broader calls for tax reform that prioritizes neutrality and horizontal equity, ensuring that identically situated taxpayers face similar tax burdens regardless of the specific investment vehicle they choose. The act does not seek to eliminate capital gains tax, but rather to harmonize its timing across comparable investment products.

Projected Fiscal and Economic Impacts

An analysis by the Tax Foundation provides a conventional estimate of the GROWTH Act’s potential fiscal impact on federal revenue. On a conventional basis, the proposal is projected to reduce federal revenue by an estimated $37.7 billion over the fiscal years 2027 to 2036. This cost profile is characteristic of tax timing changes; it is heavily "front-loaded." In the initial years, as previously taxable reinvested capital gains distributions begin to qualify for deferral, the government experiences a significant reduction in immediate tax collections. During this phase, investors are deferring taxes on new gains, but no significant amount of previously deferred gains has yet been sold and recognized for tax purposes.

However, as the budget window progresses and investors eventually sell their fund shares, these deferred capital gains would then become taxable. This recognition of deferred liabilities leads to a gradual reduction in the net revenue cost. The Tax Foundation projects that the annual revenue loss would fall substantially over time, reaching a "steady-state" cost of just above $1 billion per year in the latter part of the budget window. Despite this decline, the proposal is expected to incur a net long-run cost to the federal government. The modeling notes from the Tax Foundation also suggest that the conventional revenue cost might ultimately be somewhat smaller than estimated, as reinvested returns that constitute deferred tax liability can themselves compound and eventually be subject to tax, an effect not fully captured in the initial conventional estimate.

Table 1. Conventional Revenue Effects of the GROWTH Act Mutual Fund Capital Gains Deferral
Billions of Dollars, 2027-2036
Source: Tax Foundation General Equilibrium Model, September 2026.
Aggregate Revenue Reduction: $37.7 Billion (2027-2036)
Initial Period: Higher revenue loss due to immediate deferrals.
Later Period: Lower steady-state cost as deferred gains are recognized upon sale.

Distributional Effects and Economic Growth

Beyond the aggregate revenue impact, the GROWTH Act is also projected to have distributional effects across various income levels. According to the Tax Foundation’s analysis, the proposal would lead to an average increase in after-tax incomes of 0.1 percent in 2027. This initial impact is largely driven by the immediate deferral of capital gains tax liabilities for mutual fund investors, benefiting those who hold taxable mutual funds. By 2036, as the "front-loaded" effect diminishes and deferred gains begin to be recognized, the change in tax liabilities is projected to be smaller, resulting in an increase of less than 0.05 percent in after-tax incomes across the income spectrum. This indicates a broad, albeit modest, benefit to investors across various income brackets over the long term.