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 total assets under management. The continuous decline of active funds is a cause for concern. Active funds engage with and monitor management and participate in their portfolio companies’ decisions. The costs of these activities are born exclusively by active funds; the benefits, by contrast, are spread over all shareholders, including passive funds that free-ride on the efforts of active funds. Consequently, the contraction of active funds threatens to diminish the quality of corporate governance in U.S. firms. Our tax law exacerbates the problem, give passive funds more favorable tax treatment, relative to active ones.

In a recent article, we propose a novel way to reverse this trend. To preserve the benefits of active funds, we explore the possibility of employing tax mechanisms to help defray the extra cost born by active funds. In particular, we argue for using tax credits to support active funds and enhance their market share. We also argue that, at a minimum, active funds should be subject to the same tax burden as passive ones, 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 an active fund undertakes specified 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 would 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 credit would provide a firm tax credits based on certain outcomes, such as passing a shareholder proposal, winning a proxy contest, gaining representation on a board, or increasing share values. A result-based credit would be calculated after controlling for non-governance factors such as market-wide or sector movement of share prices and firm-specific commercial events.

There is a tradeoff between the two forms of credits. The effort-based credits are less vulnerable to manipulation because typically the firm doesn’t obtain a net-gain from the credit – it only covers the firm’s 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.

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 (Kaplow & Shavell, 2002). 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, whose monitoring costs the government cannot accurately measure. This is the main reason why our suggestion for addressing the problem is better than alternative solutions based on command and control mechanisms, such as mandatory participation (Mallin, 2012) and expense levels (Bebchuk & Hirst, 2019).

Second, our proposal has the potential to create a virtuous financial cycle: The expected increase in tax revenues from both a shift to investments with more frequent realization, leading to higher effective tax rates, and the improved performance of firms generated by the tax, should far surpass the cost of providing the credits. The average turnover ratio of securities in active funds is three times higher than that of passive funds: 74 percent as opposed to 24 percent in passive funds (Crane & Crotty, 2018). As a consequence, profits are more often realized, as are the tax liabilities 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 would create a virtuous cycle, increasing the incentive to improve corporate governance across the board. As a consequence, they will increase the profitability of firms and, correspondingly, the amount of tax revenues.

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.

This post comes to us from professors Adi Libson at Bar-Ilan University – Faculty of Law and Gideon Parchomovsky at the University of Pennsylvania Law School. It is based on their recent article, “Reversing the Fortunes of Active Funds,” available here.