Home Policy Priorities Testimony
Print this pageStatement of the Investment Company Institute
Submitted to the Committee on Ways and Means
U.S. House of Representatives
On the President’s Economic Growth Proposals
Included in the Fiscal Year 2004 Budget
March 18, 2003
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Table of Contents
II. The Need to Encourage Savings
III. The Mutual Fund Industry’s Role in American Savings
IV. Application of the Dividend Exclusion to Mutual Fund Shareholders
B. Regulated Investment Company Rules
V. The Dividend Exclusion’s Impact on Savings
VII. Institute Support for Other Savings Initiatives
I. Summary Points
- The Need to Encourage SavingsEncouraging Americans to save for their long-term financial security is of vital importance to our nation’s future.
- The Mutual Fund Industry’s Role in American SavingMutual funds play an important financial management role for over 90 million, overwhelmingly middle-income, Americans who invest in mutual funds through taxable accounts, retirement accounts and qualified tuition programs (Section 529 Plans).
- Application of the Dividend Exclusion to Mutual Fund ShareholdersThe proposal’s tax benefits would be provided to direct investors and mutual fund shareholders. Funds may be expected to distribute these benefits frequently to their shareholders. Those millions of mutual fund shareholders who receive average cost statements from their funds would have all calculations performed for them.
- The Dividend Exclusion’s Impact on SavingsThe Institute strongly supports this proposal because it most likely would have a strong, positive impact on taxable investing in equities and a modest impact on municipal bonds. Although the proposal would not apply to equities held in a retirement account, investors would continue to have an incentive to hold equities through their retirement accounts and would benefit from the proposal’s positive impact on the stock market.
- Mutual Fund Capital GainsFinally, the Institute supports legislation that would permit the deferral of the payment of tax on a capital gain realized by a fund until the fund shareholder receives the gain in cash, such as by redeeming fund shares.
- Institute Support for Other Savings InitiativesThe Institute has long supported efforts to enhance financial security by advocating efforts to encourage retirement savings through employer-sponsored plans and IRAs, to simplify the rules applicable to retirement savings vehicles, to enable individuals to better understand and manage their retirement assets, and to encourage college savings.
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The Investment Company Institute (the "Institute")1 is pleased to submit for the Committee's consideration this statement strongly supporting the President’s proposal to promote economic growth and encourage savings by eliminating the double taxation of corporate earnings. The dividend exclusion incorporated in H.R. 2 achieves this objective through provisions that are designed to maximize economic efficiencies and minimize administrative burden. This legislation represents an important step in enhancing the ability of Americans to meet their own needs for long-term financial security.
The Institute has discussed the dividend exclusion proposal with Treasury Department representatives on numerous occasions and with Committee staff. We appreciate greatly their receptivity to our suggestions for modest, conforming changes that will make the proposal even more administrable for investors generally and, more particularly, for the millions of mutual fund shareholders investing for the future in equities through taxable accounts.
II. The Need to Encourage Savings
Encouraging Americans to save for their long-term financial security is of vital importance to our nation’s future. As Dr. Rudolph G. Penner stated at the beginning of his paper, “Reducing the Tax Burden on Saving,” that was published by the Institute in 1994,
A nation’s savings provide the foundation for its economic growth. Nations that do not save will in the long run see their potential for increased income and wealth suffer. For that reason, the current savings rates in the United States, low by historical and international standards, raise concerns that the United States will grow more slowly than it should and that the standard of living of its citizens will be lower than it need be. The cause of the falling savings rate has been the subject of much debate. Although the cause is not clear, the trend may be reversed by reducing the tax burden on saving.2
III. The Mutual Fund Industry’s Role in American Saving
Mutual funds play an important financial management role for over 90 million Americans. Overwhelmingly, these investors are middle-income Americans who invest in mutual funds for the diversification, professional management and varying investment objectives that funds provide. Americans may invest in funds through taxable accounts, retirement accounts, or qualified tuition programs (more commonly known as Section 529 Plans). As these funds have grown, they’ve played a leading role in democratizing our financial markets. American investors now represent a broad cross-section of society and a powerful engine for economic recovery.
At the end of 2003, U.S. mutual funds had total assets of $6.391 trillion. Of this amount, approximately 42 percent (or $2.667 trillion) was invested in equity funds, approximately 18 percent (or $1.125 trillion) was invested in bond funds, approximately 5 percent (or $0.327 trillion) was invested in hybrid funds,3 and the remaining 35 percent (or $2.272 trillion) was invested in money market funds.4
Mutual funds function as an important investment medium for employer-sponsored retirement programs (e.g., section 401(k) plans) as well as for individual savings vehicles (e.g., individual retirement accounts (“IRAs”)). As of December 31, 2001, mutual funds held approximately $2.3 trillion in retirement assets, including $1.2 trillion in IRAs and $1.1 trillion in employer-sponsored defined contribution plans.5 These figures represented about 49 percent of all IRA assets and 44 percent of all 401(k) plan assets.
While many are aware that more than half of all U.S. households invest in mutual funds, the impact that growing mutual funds have had on the economy is less fully appreciated. A few years ago, The Economist said that mutual funds had emerged as “the biggest source of capital for American companies . . . giving small and medium-sized businesses unprecedented access to capital markets and thereby financing nearly all of America’s employment growth.”6
In short, mutual funds are both an essential vehicle for enabling middle-income Americans to reach their long-term savings goals, including retirement, and an important source of capital and growth for the American economy.
IV. Application of the Dividend Exclusion to RICs and Their Shareholders
A. General Rules
Under the President’s proposal, a corporation’s fully-taxed earnings may be distributed tax-free to the corporation’s shareholders either as a tax-free cash distribution (an “excludable dividend” or “ED”) or by adjusting upward the cost basis of each shareholder’s shares (a “retained earnings basis adjustment” or “REBA”). Once a corporation distributes its earnings as an ED or a REBA, no further income tax will ever be imposed on those earnings.
A corporation also can make a tax-free distribution to its shareholders, under the President’s proposal, out of its “cumulative retained earnings basis adjustment amount” or “CREBAA” and reducing the amount of its cumulative REBAs by the amount distributed. A cumulative retained earnings basis adjustment (“CREBA”) distribution is treated in the hands of an investor exactly the same as a return of capital; each provides tax-free cash to the investor (to the extent of the shareholder’s basis) and requires a downward adjustment in share basis equal to the cash distributed.
B. Regulated Investment Company (“RIC”) Rules
The dividend exclusion tax benefits provided to direct investors in equity securities also are provided under the President’s proposal to the shareholders of a fund organized as a regulated investment company (“RIC”) under Subchapter M of the Code, hereinafter referred to as a “fund.” A fund that receives EDs, REBAs and CREBAs on its portfolio stocks could pay/allocate them periodically to its shareholders on a flow-through basis. Funds may be expected under the President’s proposal to pay EDs and allocate REBAs frequently, as fund shareholders would benefit from an ED or REBA only to the extent that it had been paid or allocated by the fund to its shareholders.
Many millions of mutual fund shareholders would not need to individually make the basis adjustments required by the REBA and CREBA regimes, as they already are entitled to receive average cost basis statements provided to them voluntarily by their funds. Once the funds have modified their cost basis programs for REBAs and CREBAs, the funds themselves would make the necessary adjustments to the cost basis of their shareholders’ shares. Those shareholders who either do not receive, or choose not to use, average cost basis statements provided to them by their funds would need to make these adjustments themselves (such as with the use of a computer program designed for this purpose) or rely on their tax return preparers or financial advisors to assist them.
C. Retirement Accounts
The President’s proposal does not apply to retirement accounts. As noted in the Treasury Department’s General Explanations of the Administration’s Fiscal Year 2004 Revenue Proposals, “[b]ecause all investment income is effectively free from tax in Retirement Plans, investments in these plans will remain tax advantaged relative to investments outside of these plans.”7
V. The Dividend Exclusion’s Impact on Savings
The mutual fund industry’s role in Americans’ efforts to achieve financial security provides the Institute with a unique perspective with respect to the dividend exclusion and its impact on various savings opportunities.
The proposal would have a strong, positive impact on taxable investing in equities. Eliminating the investor-level tax on corporate dividends would substantially increase after-tax returns on equities which, in turn, should raise stock prices and promote long-term savings.
The impact of the proposal on municipal bonds most likely would be modest. Although the proposal would raise the risk-adjusted after-tax return on equities relative to bonds, equities and municipal bonds are not generally viewed as ready substitutes for each other. Taxable bonds are a far better comparable for municipal bonds, and the relative after-tax yield on the taxable bond versus the municipal bond yield is often the determining factor in deciding whether to invest in municipal bonds.
Finally, although the proposal does not apply to equities held in a retirement account, any investor eligible to make pre-tax contributions to a retirement account or after-tax contributions to a Roth IRA would still receive more favorable treatment by investing in the retirement account than by investing in the same assets through a taxable account. This result would occur unless 100 percent of the return on a stock was in the form of a tax-free distribution of an ED, a REBA or a CREBA.8 Moreover, retirement accounts investing in equities would receive the same benefit that taxable accounts would receive from the rise in stock prices generated by the proposal. Thus, investors would continue to have an incentive to hold equities through their retirement accounts and would benefit from the proposal’s positive impact on the stock market.
VI. Mutual Fund Capital Gains
The Institute supports legislation that would permit the deferral of the payment of tax on a capital gain realized by a fund until the fund shareholder receives the gain in cash, such as by redeeming fund shares. This proposal would remedy the anomalous result, misunderstood by many fund shareholders, that capital gains realized by the fund are taxed currently to the fund’s long-term mutual fund shareholders—who continue to hold, rather than sell, their shares.
If this type of legislation were enacted, the fund shareholder’s own actions would determine when taxes are paid. This would benefit the millions of fund shareholders investing in taxable accounts. These investors are mainly middle-income investors who are providing capital necessary for continued economic growth.
By reducing current tax bills and allowing earnings to grow tax-deferred, this legislation would boost long-term savings. Moreover, the proposal would not result in these gains being excluded from tax. Instead, the gains would merely be deferred, albeit, in some cases, outside the relevant budget-scoring period. The proposal’s boost to long-term savings would have little, if any, long-term cost and would provide benefits to the economy in both the short run and the long run.
VII. Institute Support for Other Savings Initiatives
Finally, the Institute has long supported efforts to enhance financial security by advocating efforts to encourage retirement savings through employer-sponsored plans and IRAs, to simplify the rules applicable to retirement savings vehicles, to enable individuals to better understand and manage their retirement assets, to encourage college savings, and to reduce the tax burden on other long-term investing through mutual funds.
The President’s budget includes several important savings incentives, in addition to the proposal to eliminate the double taxation of corporate earnings. One bold initiative is the proposed creation of Retirement Savings Accounts, Lifetime Savings Accounts and Employer Retirement Savings Accounts. These three new retirement and savings vehicles would both enhance the ability of Americans to save for their future and simplify the current rules governing retirement plans. The Institute strongly supports savings and simplification initiatives that would bring long-term savings and investment opportunities within the reach of every working American.
The President’s budget detailed other important retirement savings initiatives that the Institute endorses, including proposals to accelerate the savings enhancements, and make permanent the pension law enhancements, that were enacted two years ago as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”).
The Institute supports accelerating the phase-ins of the increases, enacted as part of EGTRRA, in the contribution limits to IRAs and employer-sponsored retirement plans and in the opportunity for individuals age 50 and over to make “catch-up” contributions to their pension plans and IRAs. Accelerating the phase-ins will increase saving and boost economic growth.
The Institute also supports making permanent as soon as possible the EGTRRA enhancements to our pension laws—which likewise encourage economic growth. For individuals to plan appropriately for their retirement years, they must be able to rely on predictable rules—rules that apply now and throughout one’s career and retirement.9 The future termination of these provisions could affect the long-term savings strategies of working individuals, undermining the purpose of these reforms and jeopardizing saving and long-term growth.
Because education helps increase productivity, saving for higher education promotes economic growth in both the near-term and the long-term. The Institute supports prompt enactment of legislation making permanent the tax-free treatment of qualified withdrawals from Section 529 plans because of the disproportionate impact that this uncertainty is having today. EGTRRA provides no up-front benefit to taxpayers, but instead provides that future qualified withdrawals will be tax-free. Consequently, EGTRRA’s sunset provision creates immediate uncertainty for families who are trying to save now to meet college expenses that will arise after 2010. Legislation making permanent the tax-free treatment of qualified withdrawals from these plans will promote growth and encourage long-term savings. For this reason, it should be a priority.
VIII. Recommendation
The Institute strongly supports common-sense initiatives that will promote savings. Thus, we urge enactment of the H.R. 2 provisions that would eliminate the double taxation of corporate earnings. We support capital gains tax relief for mutual fund shareholders. Finally, we also support savings incentives for retirement and college education.
ENDNOTES
1 The Investment Company Institute is the national association of the American investment company industry. Its membership includes 8,929 open-end investment companies ("mutual funds"), 553 closed-end investment companies, and six sponsors of unit investment trusts. Its mutual fund members have assets of about $6.322 trillion, accounting for approximately 95 percent of total industry assets, and 90.2 million individual shareholders.
2 “Reducing the Tax Burden on Saving,” p. 1, Investment Company Institute, December 1994.
3 A hybrid fund is one that invests in a combination of stocks, bonds and other securities.
4 Mutual Fund Industry Developments in 2002, Perspective, Vol. 9, No. 1, Investment Company Institute (February 2003).
5 Mutual Funds and the Retirement Market in 2001, Fundamentals, Vol. 11, No. 2, Investment Company Institute (June 2002).
6 “The Seismic Shift in American Finance: Mutual Funds,” The Economist, October 21, 1995.
7 “General Explanations of the Administration’s Fiscal Year 2004 Revenue Proposals,” p. 21, U.S. Department of the Treasury (February 2003).
8 As noted above, retirement accounts effectively provide a zero rate of tax on return. In contrast, a taxable account would only provide tax-free treatment on the portion of the investment return attributable to EDs, REBAs, or CREBAs.
9 Americans will be better positioned to build an adequate retirement plan if they know now whether, for example, they will be able to contribute $2,000 or $5,000 to an IRA in 2011 and whether they will be able to make catch-up contributions.
