Capital gains taxes, the sequel

June 14, 2024

Vanderbilt's former Dean of Students Madison Sarratt once summarized the university's honor code as such:

"Today I am going to give you two examinations, one in trigonometry and one in honesty. I hope you will pass them both, but, if you fail one, let it be trigonometry, for there are many good men in this world today who cannot pass an examination in trigonometry, but there are no good men in the world who cannot pass an examination in honesty."

The financial world should take note.

The main topic today is one that no one ever disagrees about, and one that engenders no emotion: taxes. I promised you an update on capital gains taxes, and after the quote about honesty, I feel compelled to deliver.

You cannot have a productive economic system without labor and capital, and if you are short either, things do not work well.

The reason this relates to capital gains tax rates is that if the rates are high, capital tends to lock into silos. When you are raising money for a startup, for example, an investor who wants to invest in your startup generally has to sell something else to do so. If that investor has a 30% tax to pay, she is going to think twice about doing so. In many cases she won't, and a good idea or business will wither because of the tax-imposed friction. No capital means no jobs.

This shows up in publicly traded mutual funds and ETFs all the time. One of the advantages to being an established fund player when capital gains rates are high is that you worry less about investors leaving your fund, because you know in brokerage accounts those investors will have a tax on the way out. This protects you as the establishment, and puts a headwind on the more efficient disruptor. At One Day In July, we try to figure out how to unwind this predicament for new clients, but there isn't always a good solution.

Frequently, we see similar funds from the same ETF provider, priced at different levels. It's obvious what is going on: they want to preserve the high profit margins in the older fund, knowing many of the investors cannot leave due to capital gains taxes, and yet they want to capture new money inflows and need a more competitive price. So they create a new ETF that is basically the same thing, but at a lower price.

We have inquired to these fund companies about this, and the responses would be amusing if so much money weren't on the line. Ok, ok, trying to get back to the honesty thing... the responses are amusing. We feel a little badly because the employees at those firms can't just say what we know or they'll probably lose their jobs. I mean I would be tempted to respond:

Well Dan this thing is a cash cow at these price points. I mean we have a fund manager, a few associates, a sales team, and a bunch of software on this beauty and it's running $44 billion at 0.15%. It's tracking an index we license, so not much to do! While we're out on the golf course do yourself a fun-one and run that through your calculator." (Hypothetical me did, it's $66 million in revenue.)¹

We at least feel like we should put some pressure on them to lower prices.

One way to address this would be to drop the capital gains rate to zero. But this would have other issues in that capital can compound disproportionately. With no taxation on capital, ever, the system will go out of balance.

This is a hard problem. One idea is to lower rates on people who are alive and making decisions, and offset that by raising them via the estate tax on people who are not alive and not making decisions.

- Dan Cunningham

1. Note that 0.15% is still an excellent price to the investor versus most funds. One Day In July averages at about 0.06% fund fees on new portfolios, though it varies by portfolio and circumstance. Click here or here to learn more on our site (sources listed here as well).