Paul L. Caron

Wednesday, January 22, 2020

Using Tax Credits To Reverse The Fortunes Of Active Funds

Adi Libson (Bar-Ilan University) & Gideon Parchomovsky (University of Pennsylvania), Reversing the Fortunes of Active Funds:

Recent years have witnessed a considerable growth of passive fund at the expense of active funds. This trend picked in 2019, a year that saw passive funds surpass active funds in terms of assets under management. The continuous decline of active funds is a cause for concern. Active funds engage in monitoring of firms and partake of decision-making in companies in their portfolio. The cost 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. The contraction of active funds threatens to set back the quality of corporate governance in U.S. firms.

This Essay proposes a 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 discuss two types of tax credits: effort based tax credits and result-based tax credits.

The use of targeted tax credits has four principal advantages over competing proposals. Effort based tax credits would be granted whenever an 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.

Our proposal has three potential advantages over competing proposals 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. Second, our proposal has the potential to create a virtuous financial cycle: the expected increase in tax revenues from the improved performance of firms generated by the tax should far surpass the cost of providing the credits. 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.

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Nice paper, including the point about inefficient bias toward buy-and-hold! Any such interventions ought to be conservative considering compliance challenges with even the earned income tax credit.

The TCJA also stands to help price discovery - and much more - by bringing combined corporate and shareholder rates closer to the top individual and passthrough rates, greatly reducing the bias against public trading (and in favor of the very rich) that the Clinton Treasury's check the box regs had codified.

Posted by: Anand Desai | Jan 22, 2020 5:57:12 AM

Forgive me, but I have no sympathy for actively managed funds that have delivered subpar results while collecting exorbitant fees for decades. Hats off instead to the investors who've had enough and switched instead to passive funds.

In addition (be honest now) how much good have actively managed funds actually done in terms of improving corporate governance. Not enough, not even close, to propose that taxpayers in general should now prop up those funds.

Posted by: Gerald Scorse | Jan 22, 2020 8:34:01 AM

Seriously, you want to reward firms that overcharge for their services?

Posted by: Dale Spradling | Jan 22, 2020 8:57:08 AM

Even "more seriously", will they even attempt to measure, let’s give it a name, “Woke Alpha”, such that tax credits and higher fees accrue only in proportion to outperformance attributed solely to superior corporate board actions? Would one say that, say, PG&E’s board (and their policies) the product of brain dead, index passivity?

Posted by: MG | Jan 26, 2020 2:03:58 AM