In Reversing the Fortunes of Active Funds, Adi Libson and Gideon Parchomovsky propose a novel, tax-oriented solution to a well-established and important problem in the literature on corporate governance: the rise of “passive” investment funds as substantial shareholders in publicly traded companies. Libson and Parchomovsky argue that these passive funds engage in limited oversight with respect to their massive stock holdings. Downward cost pressure discourages informed or engaged voting with one’s hands, and slavish fidelity to benchmark indices precludes voting with one’s feet. The result is that passive funds (and many retail investors, and perhaps society as a whole) free-ride on active funds’ efforts to monitor management. For Libson and Parchomovsky, the answer is a Pigouvian subsidy, administered through the income tax system, to these active funds—the reversal of fortune referenced in their article’s title.
The relationship between taxation and corporate governance has a long and storied history among lawmakers as well as academics. Although more squarely oriented towards corporate law debates than tax ones, Libson and Parchomovsky’s article represents a valuable addition to this body of work. Libson and Parchomovsky make a strong case for price instruments as an effective means of encouraging funds to self-sort along a spectrum of behaviors that yield positive externalities. Identifying and attaching prices to these good behaviors seems likely to prove difficult, however. The result probably will be fairly complex, and almost certainly will require a periodic tweak or two (perhaps to contain any gaming that emerges). Bear in mind that we’re talking taxation, and those tax lawyers surely are up to the task. But one hopes that Libson and Parchomovsky aren’t foisting a complicated regulatory regime onto the tax system just because it’s a palatable place to stash those kinds of things.
Libson and Parchomovsky outline the contours of a compelling idea—a tax credit for active fund behaviors—that naturally caused my mind to wander to the nuts and bolts of their proposal. For me, the primary issue is that these funds generally aren’t paying much income tax, if any, to which a (nonrefundable) credit might apply. Mutual funds, whether active or passive, tend to qualify as regulated investment companies under the Code, which allows for conduit treatment. Dividend income and capital gains generally are passed through to shareholders with no fund-level tax due. A quick glance at the statistics of income shows that, in the aggregate in 2013, open-end RICs—conventional mutual funds—paid less than $10 million in tax on roughly $325 billion of net income. That’s not a lot to work with. If Libson and Parchomovsky want their credit to end up with the fund, at least nominally, then the credit presumably needs to be refundable. And that’s a political hurdle that vanishingly few business credits have surmounted.
Nonrefundable credits might work, if they passed through to the shareholders of active funds. After all, that’s really the point of the RIC regime. But these funds’ shareholders are often themselves tax-exempt—retirement plans, for example. Even for holdings in taxable accounts, a year-end credit on one’s Form 1099 might not have the salience needed to drive investors towards active funds and away from their passive, credit-less counterparts. Perhaps the story revolves around a subset of hyper-aware (taxable) mutual fund investors, or the systematic incorporation of the credits into well-traveled metrics such as rates of return, expense ratios, or third-party ratings. The optics still aren’t great, in that the credits end up in the hands of either mutual fund managers or higher-income investors, at least on a nominal basis. Libson and Parchomovsky contend that fund managers, as an interest group, are unlikely to oppose these types of tax credits, but it’s also hard for me to envision a champion for their recommendation.
Setting aside politics and mechanics, there remains a question of distributional outcomes under Libson and Parchomovsky’s proposal. Ultimately, their Pigouvian subsidy is a transfer from one group of people to another, and, even if this transfer enhances efficiency, we might care about the identity and composition of transferors and transferees. Libson and Parchomovsky allude to the possibility that increased realizations—from increased fund activity—might fund all or a portion of their tax credits. This funding source, however, could be plumbed more fully to assign incidence (and my intuition is that there’s less revenue there than one might think, given the RIC conduit regime and the prevalence of tax-exempt investors). Alternatively, the credit might be funded through an excise tax on all investment funds, or on institutional investors, or on capital or capital transactions more broadly. The sources might reflect the uses, with the hope that any redistribution comes out in the wash. Finally, Congress might look to general revenues (or borrowings) for the cash. One need not be an abject cynic to see the political appeal in this last option, and one need not be too far to the left to view such politics as leading to potentially pernicious upward redistribution.
Overall, Libson and Parchomovsky’s article offers a fresh and timely prescription to address a crucial challenge in corporate governance—a challenge whose urgency seems likely to grow over time. Academics both inside and outside of tax should find Libson and Parchomovsky’s proposals provocative, and policymakers should give serious consideration to reforms along the lines suggested by the authors.