Skip Navigation
| Skip Navigation |
|
|
|
|
|
|
Numbers in the text and tables of this memorandum may not add up to totals because of rounding. |
This Congressional Budget Office (CBO) memorandum was prepared in response to the rapid increase in capital gains distributions paid out by mutual funds in the 1990s. That increase has raised questions about how important distributions by mutual funds are to federal income tax revenues--particularly revenues from realized capital gains.
The memorandum was written by Larry Ozanne of CBO's Tax Analysis Division under the direction of Roberton Williams and G. Thomas Woodward. In preparing the analysis, the author received helpful suggestions and information from staff members of the Investment Company Institute, the Board of Governors of the Federal Reserve System, the Office of Tax Analysis at the Department of the Treasury, and the Statistics of Income Division at the Internal Revenue Service.
Christian Spoor edited the manuscript, and Sherry Snyder proofread it. Simone Thomas prepared the memorandum for publication, and Laurie Brown prepared the electronic versions for CBO's World Wide Web site (www.cbo.gov).
Questions about this analysis may be addressed to Larry Ozanne.
MUTUAL FUNDS AND THEIR CAPITAL GAINS DISTRIBUTIONS
THE TAXATION OF CAPITAL GAINS DISTRIBUTIONS
CAPITAL GAINS ON THE SALE OF MUTUAL-FUND SHARES
THE NET IMPACT OF STOCK AND BOND FUNDS ON TAXABLE GAINS
APPENDIX: TESTING FOR THE
NET IMPACT OF STOCK AND BOND FUNDS ON TAXABLE GAINS
| TABLES | |
| 1. | Assets in U.S. Mutual Funds at the End of 1998 |
| 2. | Percentage of Capital Gains Distributions from Stock and Bond Funds Reported on Tax Returns, 1981-1998 |
| 3. | Distributions from Stock and Bond Funds as a Percentage of Total Capital Gains Reported on Tax Returns, 1981-1997 |
| 4. | Assets in Stock Funds, by Category of Ownership, 1980-1997 |
| 5. | Comparing the Share of Distributions Reported on Individual Income Tax Returns with the Share of Stock-Fund Assets Held in Traditional Accounts |
| 6. | Assets in Stock and Bond Funds, by Type of Institutional Owner, 1995 |
| 7. | Allocation of 1997 Capital Gains Distributions, by Tax Treatment |
| A-1. | Three Measures of Mutual-Fund Activity, 1955-1997 |
| A-2. | Regression Statistics from Four Ratio Equations |
| A-3. | Regression Statistics from Four Growth-Rate Equations |
| A-4. | Regression Statistics for MFSHARE in All Equations |
| FIGURES | |
| 1. | Total Assets in Stock and Bond Funds, 1950-1998 |
| 2. | Stock-Fund Assets and Bond-Fund Assets, 1970-1998 |
| 3. | Stock- and Bond-Fund Assets as a Share of Total Household Assets, 1950-1998 |
| 4. | Total Assets in Stock Funds and Capital Gains Distributions from Stock and Bond Funds, 1970-1998 |
| 5. | Capital Gains Distributions Paid by Stock and Bond Funds and Reported on Tax Returns, 1981-1997 |
| A-1. | The MFSHARE Variable and the Ratio of Total Capital Gains to Potential GDP, 1955-1997 |
| A-2. | Total Taxable Gains and Capital Gains Distributions Reported on Tax Returns, 1955-1997 |
| BOXES | |
| A-1. | Estimating Taxable Stock-Fund Assets Before 1980 |
Mutual funds pool money from shareholders and invest in a diverse portfolio of securities. The funds earn income from the dividends and interest paid on those securities; they also earn capital gains when they sell securities for more than they paid for them. As long as the funds distribute most of the income they earn in a year to their shareholders, that income is taxed as income to the shareholder, not the fund. The federal income tax applies lower tax rates to long-term capital gains (gains realized on assets held for at least a year), so mutual funds identify those gains separately as capital gains distributions. The vast majority of capital gains distributions are earned by stock funds, with bond funds earning the rest.
Capital gains distributions from stock and bond funds have been rising rapidly for the past two decades. Between 1990 and 1997 alone, they soared from $8 billion to $183 billion. That amount of growth equals two-thirds of the increase in capital gains reported on individual income tax returns between 1990 and 1997. Furthermore, the growth of those distributions between 1994 and 1997 was large enough that it could have caused one-fourth of the unexpected surge in federal revenues from individual income taxes that occurred in fiscal years 1996 through 1998.
Did the rapid growth of capital gains distributions from mutual funds cause the simultaneous surges in taxable capital gains and income tax revenues? Although many people have speculated that it may have, this analysis concludes that it did not. The reason is that two factors muted the impact of mutual-fund distributions on taxable capital gains and tax revenues. First, less than half of the distributions paid in recent years were taxed as capital gains. And second, some of the distributions that were taxed probably substituted for gains on directly held stocks.
Individual income tax returns provide direct evidence about the amount of capital gains distributions paid out by mutual funds in one year that become taxable income for the same year. The amount of such distributions reported on tax returns has grown less rapidly than the amount paid by mutual funds. In the early 1980s, total distributions reported by taxpayers were nearly equal to total distributions paid out; by 1990, they represented only about one-half, and by 1997, about one-quarter.
The tax status of the remaining capital gains distributions is not known for certain. But indirect evidence about that status comes from information about who owns shares in stock funds. From the 1920s, when stock funds began, through the 1950s, nearly all shares were held directly by individuals in taxable form. Since then, various institutions have started purchasing shares in stock funds. Between 1980 and 1997, the fraction of stock-fund assets held in traditional, individual accounts declined from 66 percent to 28 percent, according to one source of data. That decline accounts for the declining share of capital gains distributions reported on tax returns.
The falling percentage of stock-fund assets held in traditional accounts has largely resulted from the rapidly rising percentage of assets held in pensions, individual retirement accounts, and insurance company products called variable annuities. In 1997, those three types of accounts held 57 percent of stock-fund assets. Capital gains distributions received by those accounts are tax-deferred until they are paid out to individual beneficiaries, often years after they are received. Furthermore, payouts from those accounts are taxed as part of beneficiaries' ordinary income, so they are not identified as capital gains distributions at that time. Thus, distributions paid to those three types of accounts never show up in taxable capital gains.
A variety of other institutions--ranging from trusts and estates to corporations, nonprofit institutions, and state and local governments--also hold stock-fund assets. Trusts and estates appear to receive about 10 percent of the capital gains distributions paid by stock funds in most years. A substantial fraction of those gains are passed along to individuals; although they are taxed as capital gains on individual returns, they are not identified as distributions from mutual funds. The rest, which are retained by the trust or estate, are taxed as gains under the fiduciary income tax. The other types of institutions that own shares in stock and bond funds most likely receive a small fraction of the capital gains distributions paid by those funds. Nonfinancial corporations probably pay taxes on the distributions they receive, but other institutions are likely to be tax-exempt.
All together, less than 40 percent of the capital gains distributions that mutual funds paid in 1997 appear to have been taxed as capital gains that year, the Congressional Budget Office (CBO) estimates.
Besides receiving capital gains distributions, owners of mutual-fund shares can realize capital gains or losses when they sell their shares. The limited information available about that source of gains, however, suggests that it adds much less to total taxable gains than distributions from mutual funds do.
The amount of capital gains distributions that become taxable income measures the gross effect of mutual-fund distributions on taxable income. The net effect is probably smaller. To the extent that mutual funds are buying and selling assets that people would have bought and sold by themselves, capital gains distributions substitute for capital gains realizations that would have occurred otherwise. Statistical regression tests performed by CBO could not identify the extent to which the distributions that become taxable individual income represent a net increase in taxable gains rather than a substitution, but some net increase is likely.
Because distributions from mutual funds make a smaller net contribution
to taxable capital gains than the amounts paid out, they account for a
small portion of the growth in taxable capital gains that occurred between
1990 and 1997. Nor have such distributions been a major component of revenue
growth in recent fiscal years. The major contributors to revenue growth
have been wages, business income, and capital gains on all assets, all
of which have grown strongly, particularly among higher-income taxpayers.(1)
1. Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 2000-2009 (January 1999), pp. 48-50; and Richard A. Kasten, David J. Weiner, and G. Thomas Woodward, "What Made Receipts Boom and When Will They Go Bust?" National Tax Journal (September 1999), pp. 339-347.
