Candice Horbacz
Investment in American financial markets is a key component of the nation’s long-term economic trajectory, underpinning innovation, job creation, and overall prosperity. The current tax treatment of investment significantly influences after-tax returns to saving and shapes how Americans choose to allocate their capital, sometimes inadvertently creating barriers to domestic investment. Recognizing this, a bipartisan legislative effort has emerged to address inconsistencies within the tax code affecting investment funds.
The Generating Retirement Ownership Through Long-Term Holding (GROWTH) Act, introduced in both chambers of Congress by Senator John Cornyn (R-TX) and Representative Beth Van Duyne (R-TX) during the current legislative session, proposes a significant adjustment to the tax treatment of investment funds. Its core objective is to improve the tax landscape for saving in the U.S. by allowing investors to defer tax on qualifying reinvested capital gains distributions until they ultimately sell their fund shares. This measure seeks to create a more level playing field for various investment vehicles and encourage sustained capital formation.
Addressing a Decades-Old Disparity: Mutual Funds vs. ETFs
The fundamental impetus behind the GROWTH Act stems from a long-standing disparity in how mutual funds and exchange-traded funds (ETFs) are treated under existing tax regulations, despite both being subject to the same tax rules as regulated investment companies (RICs). While ostensibly similar in their role as diversified investment vehicles, their operational mechanisms, particularly regarding redemptions, lead to markedly different tax outcomes for shareholders.
A conventional mutual fund, for instance, operates by directly redeeming shares from investors. When a shareholder wishes to exit their position, the fund often has to sell underlying assets to generate the cash needed to pay out the redeeming shareholder. Consider a scenario where a mutual fund holds a stock with an underlying cost basis of $20 and a current market value of $100. If a shareholder redeems $100 in mutual fund shares, the fund may be compelled to sell $100 worth of that underlying stock. This action triggers an $80 capital gain (the difference between the $100 sale price and the $20 cost basis) at the fund level. Under current law, this net capital gain is then distributed to all remaining fund shareholders, who become liable for capital gains tax even though they themselves have not sold any of their mutual fund shares. This involuntary realization of taxable gains can diminish the after-tax returns for long-term holders and create an unexpected tax burden. A capital gains tax is a levy on the profit made from selling an asset, often in addition to corporate income taxes, potentially resulting in double taxation. Such taxes can bias against saving, encouraging present consumption over investment and potentially leading to a lower level of national income.
In stark contrast, ETFs typically operate differently. Retail ETF shareholders primarily buy and sell their shares on secondary markets, much like individual stocks, rather than directly redeeming them from the fund itself. When large institutional investors, known as authorized participants, redeem blocks of ETF shares directly from the fund, they usually do so in exchange for a basket of the underlying securities, rather than cash. These "in-kind" redemptions are a crucial distinction. Because no actual sale of securities occurs at the fund level for cash, these in-kind transactions do not trigger capital gains realizations that would otherwise be distributed to remaining shareholders. This structural difference means that an investor holding virtually the same portfolio of underlying assets could face different current tax liabilities depending solely on whether they chose a mutual fund or an ETF.
This operational divergence has real-world financial consequences. Data indicates that average capital gains distributions are notably higher for mutual funds than for ETFs. While investors in both fund types are ultimately subject to capital gains tax upon the sale of their own fund shares, mutual fund investors can incur this liability even while actively holding their positions, impacting their compound returns and overall wealth accumulation.
The Genesis of the GROWTH Act and its Core Provisions
The GROWTH Act emerges from a broader legislative interest in ensuring tax policy supports, rather than hinders, long-term economic objectives. Senator Cornyn and Representative Van Duyne have positioned the bill as a measure to enhance fairness and efficiency within the U.S. investment landscape. Their proposal seeks to narrow the difference in the timing of capital gains taxation between mutual fund and ETF shareholders by allowing for the deferral of tax on qualifying reinvested capital gains until the investor decides to sell their fund shares. It is important to note that this deferral would apply specifically to capital gains distributions that are reinvested; dividend and interest income would continue to be taxed under current law as they are typically considered ordinary income.
From a tax neutrality perspective, a core principle of sound tax policy dictates that the tax code should be designed such that investors make decisions about underlying investments and the fund vehicles they use based on their economic merits, rather than primarily for tax avoidance or minimization purposes. The current disparity between mutual funds and ETFs violates this principle, creating an artificial incentive to choose one fund type over another due to tax implications rather than investment strategy. The GROWTH Act aims to correct this distortion, fostering a more neutral and equitable investment environment.
Economic and Fiscal Projections: Understanding the Impact
Any proposed change to the tax code necessitates a thorough analysis of its fiscal implications. Estimates suggest that the GROWTH Act proposal would reduce federal revenue by approximately $37.7 billion over the conventional 10-year budget window, specifically from 2027 to 2036. This revenue impact is not uniform over time; it is front-loaded. The initial years see a larger revenue reduction as reinvested amounts, which would have previously been subject to immediate capital gains tax, now qualify for deferral. During this initial period, few of these deferred amounts would have been sold, meaning the tax revenue is simply postponed.
However, the net cost to the federal government is projected to decrease significantly over time as these deferred amounts are eventually sold and their associated capital gains are recognized and taxed. By the latter part of the budget window, the annual revenue loss is estimated to stabilize at just above $1 billion per year. While the proposal would incur a net long-run cost to the federal government, this cost substantially falls as prior deferred gains are eventually recognized. Furthermore, it is worth noting that the conventional revenue estimate may be somewhat conservative. In the long run, the reinvested returns that make up the deferred tax liability can themselves compound, potentially leading to higher taxable gains when the shares are eventually sold, an effect not fully captured in the initial conventional estimate.
Beyond federal revenue, the GROWTH Act also has distributional implications, affecting different income brackets. In 2027, the proposal is estimated to increase after-tax incomes by an average of 0.1 percent across all income groups. By 2036, as the initial deferral effect tapers and more gains are recognized, the change in tax liabilities is smaller, leading to an increase of less than 0.05 percent in after-tax incomes across the income spectrum. Market income includes adjusted gross income (AGI) plus various non-taxable or imputed income sources. After-tax income represents market income minus federal, state, and withholding taxes. While the direct percentage increases may appear modest, for individual investors, particularly those saving for retirement or other long-term goals, the compounding effect of deferred taxes over decades can result in substantial benefits.
From a broader economic perspective, by enhancing the after-tax returns to saving, the GROWTH Act is expected to encourage greater capital accumulation and investment. This, in turn, could increase long-run gross national product (GNP), which measures the income earned by American residents. However, the ultimate net economic impact would depend on how the associated revenue loss is financed. If the government were to finance the revenue shortfall through additional federal borrowing, the increased debt could lead to higher payments to foreign investors, potentially offsetting some of the increase in American incomes.
Industry and Expert Reactions
The financial industry, particularly organizations representing asset managers and investment companies, is expected to largely welcome the GROWTH Act. Groups such as the Investment Company Institute (ICI) and the Securities Industry and Financial Markets Association (SIFMA) have historically advocated for tax policies that simplify investment and promote long-term savings. They would likely emphasize how the bill fosters a fairer environment for mutual fund investors, encouraging greater participation in diversified investment strategies. The bill’s sponsors, Senator Cornyn and Representative Van Duyne, would undoubtedly highlight its role in bolstering American financial markets and empowering individual savers.
Tax policy think tanks, including the Tax Foundation which produced the original analysis, generally view measures that improve tax neutrality and horizontal equity favorably. They would likely underscore how the Act aligns the tax treatment of economically similar investment activities, reducing distortions that can lead to suboptimal capital allocation. While acknowledging the front-loaded revenue cost and the "lock-in" effect as trade-offs, they would likely conclude that the bill represents a targeted improvement in the tax code.
Consumer advocacy groups might also support the measure, framing it as a benefit for everyday Americans trying to build wealth for retirement or other significant life events. By reducing an often-unanticipated tax burden for mutual fund investors, the Act could simplify financial planning and enhance the attractiveness of long-term investment.
Potential Trade-offs and Broader Implications
While the GROWTH Act offers clear benefits in terms of tax neutrality and horizontal equity, it also presents certain trade-offs that are important to consider. By expanding the scope of tax deferral within the individual income tax system, the proposal could inadvertently encourage taxpayers to hold onto investments longer than they might otherwise, purely for tax purposes. This phenomenon, known as the "lock-in" effect, can prevent capital from being reallocated to more productive uses in the economy, potentially leading to misallocations of capital. If investors are hesitant to sell a position due to the immediate capital gains tax, they might miss opportunities to invest in faster-growing or more efficient sectors.
However, the GROWTH Act includes a crucial mitigating provision: it prevents taxpayers from avoiding tax altogether via the "step-up in basis" rule. The step-up in basis provision adjusts the value, or "cost basis," of an inherited asset (such as stocks or real estate) to its fair market value at the time of the owner’s death. This eliminates capital gains tax on the appreciation that occurred during the deceased’s lifetime, reducing the heir’s tax liability. By explicitly addressing this, the GROWTH Act aims to ensure that deferred gains are eventually recognized and taxed, preventing a permanent tax avoidance loophole that would significantly increase the long-run cost of the proposal.
The broader context for the GROWTH Act is the ongoing debate about comprehensive tax reform, particularly concerning the taxation of saving and investment. Many economists and tax policy experts argue for larger, more fundamental reforms, such as a shift towards a consumption tax or the widespread adoption of universal savings accounts (USAs). These more ambitious reforms aim to remove even broader distortions in the taxation of capital gains and investment income, further simplifying the tax code and encouraging long-term savings. The GROWTH Act can be seen as a targeted, incremental step towards these larger goals, addressing a specific inefficiency rather than overhauling the entire system. Ideally, the tax code should play a minimal role in influencing how taxpayers invest and which fund vehicles they choose, allowing economic fundamentals to drive these critical decisions.
Legislative Outlook
As a proposed bill, the GROWTH Act must navigate the complex legislative process. After its introduction by Senator Cornyn and Representative Van Duyne, it would typically be referred to the respective tax-writing committees in each chamber – the Senate Finance Committee and the House Ways and Means Committee. These committees would hold hearings, solicit expert testimony, and potentially amend the bill before voting on whether to send it to the full chamber for a vote. Passage in both the House and Senate, potentially requiring a conference committee to reconcile differences between versions, would then send the bill to the President for signature into law. Given its focus on tax fairness and encouraging investment, the bill may attract bipartisan support, especially if its economic benefits are clearly articulated and its fiscal implications are deemed manageable in the long run.
Modeling Methodology
The analysis supporting the GROWTH Act’s fiscal and distributional estimates relies on robust modeling techniques. Data from the IRS public use file (PUF) and statistics of income (SOI) were utilized to estimate applicable capital gains distributions, both reported directly on Form 1040 and imputed Schedule D distributions, projected forward for each year of the budget window. The model calculates the value of net deferral (deferred minus sold amounts) as a share of distributions to adjust each filer’s baseline distributions in the simulation.
Subsequently, the model calculates interactions with various components of the individual tax system, including effects on adjusted gross income (AGI), the net investment income tax (NIIT), the alternative minimum tax (AMT), tax credits and phaseouts, and the payroll tax, among other interactions within the individual tax calculator. The calculator also applies the $3,000 net capital loss deduction limit. Holding period cohorts are calculated on a pro rata realization basis for qualifying investments, anchored to IRS asset holding period data. The model assumes that pro rata realization would be enforced identically to the proposed statute, acknowledging that changes in enforcement or the underlying proposal design could impact the revenue estimate. Reinvestment rates of approximately 96 percent and a mutual fund share of combined mutual fund and REIT capital gains amounts of 93.3 percent were derived from data provided by the Investment Company Institute.
In conclusion, the GROWTH Act represents a significant legislative effort to modernize the tax treatment of investment funds in the United States. By deferring capital gains tax on reinvested distributions for mutual fund shareholders until they sell their shares, the bill seeks to address a long-standing tax disparity with ETFs, promoting greater horizontal equity and neutrality in the tax code. While it carries a front-loaded federal revenue cost and necessitates careful consideration of potential "lock-in" effects, its proponents argue that the Act would ultimately foster a more equitable investment environment, encourage long-term savings, and contribute positively to the nation’s economic trajectory.
