Reversing the Fortunes of Active Funds

Courtesy of Adi Libson and Gideon Parchomovsky

Recent years have witnessed a considerable growth of passive funds at the expense of active funds. This trend picked up in 2019, a year that saw passive funds surpass active funds in terms of total assets under management. The continuous decline of active funds is a cause for concern. Active funds monitor the management and partake of decision-making in their portfolio companies. The costs of these activities are born exclusively by active funds; the benefits, by contrast, are spread over all shareholders, including passive funds that freeride on the efforts of active funds. Consequently, the contraction of active funds threatens to set back the quality of corporate governance in U.S. firms. Perversely, our tax law exacerbates the problem: passive funds received favorable tax treatment relative to active ones.

This article proposes a novel way to reverse this trend. To preserve the benefits presented by active funds, we explore the possibility of employing tax mechanisms to help defray the extra cost born by active funds. In particular, we establish a prima facie case for using tax credits to support active funds and enhance their market share. We argue that, at a minimum, active funds should be subject to the same tax burden as passive funds, which should level the playing field in capital markets.

We discuss two types of tax credits: effort-based tax credits and result-based tax credits. Effort-based tax credits would be granted whenever active funds undertake prespecified measures to improve corporate governance, irrespective of their success. Result-based tax credits would be contingent on the attainment of certain outcomes. The two types are not mutually exclusive and can be combined for maximal effect.

Effort-based tax credits provide funds a tax credit for the expenses incurred by their monitoring activity, such as execution of proxy contests and the cost of analysts focusing on corporate governance issues and how to vote the fund’s shares. Result-based credits would provide funds a credit based on achieving certain outcomes, such as passing a shareholder proposal, winning a proxy contest, representation on the board, or increasing the shares’ value. To ensure that funds receive credits due to their actions, result-based credits would control for the impact of other non-governance factors such as market-wide or sector movement of shares and firm-specific commercial events. There is a tradeoff in the advantages of each of the two forms of credits. The effort-based credits are less exposed to manipulations because typically the firm doesn’t obtain a net-gain from the credit—it only covers its costs. In contrast, the result-based tax credit is better aligned with actual generation of market benefits, especially when based on the increase in share value.

Advantages of the Tax Credit Proposal

Our proposal has three potential advantages over competing initiatives that seek to force passive funds to become more active. First, taxes constitute a highly effective tool for altering behavior as they transform the underlying motivations of the subject. This is especially true in contexts in which the government does not have information regarding the real cost for the actors generating the externality. This holds in the case of funds, because the government cannot accurately assess their real cost of monitoring. This is the main reason why our suggestion for addressing the problem is superior to alternative solutions based on command and control mechanism, such as mandating participation and/or an expense level.

Second, our proposal has the potential to create a virtuous financial cycle. The average turnover ratio of securities in active funds is three times higher than that of passive funds: 74% as opposed to 24% in passive funds. As a consequence, realization of profits are more frequent and so are the tax liabilities which are tied to realization events. Thus, a higher turnover translates to a higher effective tax rate, in present value terms.  When taking into account the higher effective tax rate on active funds, a tax credit may essentially equalize the effective tax treatment of passive and active funds. Furthermore, the credits will increase the incentive to improve corporate governance across the board. As a consequence, they will increase the profitability of the firm, and correspondingly, tax revenues.

Third and finally, from a political economy standpoint, due to its non-coercive nature, our proposal will not attract opposition from the investment industry and thus stands a realistic chance of being adopted.

A tax credit for active funds has the ability to reverse the current shift toward passive funds and enhance the corporate governance of firms by maintaining effective monitoring of firms by competent shareholders.

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