Congress Proposes Tax on Investment Transactions: Bad News for Mutual Funds

In December 2009, U.S. Sen. Tom Harkin (D-Iowa) introduced legislation that would create a financial transaction tax on purchases and sales of securities in the U.S. markets. U.S. Rep. Peter DeFazio (D-Oregon) proposed similar legislation in the House.

Mutual funds will be especially impacted by this legislation. If the proposals are enacted, each time a mutual fund buys or sells a security it owns, it would pay a tax on the transaction. The tax rate under DeFazio’s plan would be 0.25% on stock transactions and 0.2% on options and other derivatives. The transaction tax would not apply to trades in Section 529 (College Savings) Plans, qualified retirement or health savings accounts.

Individual stock investors will receive some relief-they would receive a tax credit to offset the first $100,000 in annual stock transactions. In contrast, investors who own mutual funds, which typically trade securities in million dollar increments, would feel the full brunt of this tax. Moreover, there would be increased compliance and accounting expenses related to exempting retirement accounts, qualified plans and Section 529 plans.

Proponents of the transaction tax believe that the tax revenue would recoup some of the stimulus money borrowed from U.S. taxpayers and loaned to Wall Street firms. They also say the tax would discourage mutual funds from excessive transactions (“churning”) that raise expenses with limited benefit to customers.

The opponents (primarily the stock exchanges and mutual fund companies) believe that the tax would be passed through to mutual fund shareholders. This would have the effect of reducing fund returns to investors. In an article in Investment News magazine on January 3, 2010, Vanguard Group’s Gus Sauter predicted that the tax would add $20 billion in direct costs and as much as an additional $50 billion in wider bid-offer spreads. (A bid-offer spread is the difference between the selling price and asking price of a stock; the wider the spread, the worse it is for investors.) “That $70 billion in total costs could reduce fund returns to shareholders to 8% per year instead of the historical return of about 10% per year,” Sauter said.

U.S. and world leaders are sending conflicting signals about the tax. Treasury Secretary Timothy Geithner and President Obama oppose the tax. House Speaker Nancy Pelosi (D-California) and German Chancellor Angela Merkel favor it. So it’s too early to know if this tax will become law.

BWFA believes that if this tax is enacted:

  1. the tax would most certainly be passed through to mutual fund shareholders and result in lower returns;
  2. investment returns for actively managed mutual funds could be reduced by as much as 20%;
  3. U.S. investors would move some securities to overseas markets to avoid the tax; and
  4. the costs for exempting certain types of accounts would be substantial and also passed through to mutual fund holders.


BWFA favors using individual securities (stocks, bonds, publicly traded securities) for clients’ investments, rather than using actively managed mutual funds. We believe that individual securities provide better transparency, lower fees, better asset allocation controls, and better tax management. Also, by holding individual securities, our clients are not subject to investors’ whims that can force strategies on mutual funds.

Even where BWFA does use collective investments (such as exchange-traded funds or index mutual funds), we expect these specific funds to limit trading and therefore to incur much lower transaction taxes. By their very nature, ETFs and index funds trade far less frequently than actively managed mutual funds.

In short, BWFA believes that our investment clients will be well-positioned if the transaction tax becomes law, and we’ll keep vigilant.