Recent years have witnessed a considerable growth of passive fund at the expense of active funds. This trend picked in 2019, a year that saw passive funds surpass active funds in terms of assets under management. The continuous decline of active funds is a cause for concern. Active funds engage in monitoring of firms and partake of decision-making in companies in their portfolio. The cost of these activities are born exclusively by active funds; the benefits, by contrast, are spread over all shareholders, including passive funds that freeride on the efforts of active funds. The contraction of active funds threatens to set back the quality of corporate governance in U.S. firms.
This Essay proposes a way to reverse this trend. To preserve the benefits presented by active funds, we explore the possibility of employing tax mechanisms to help defray the extra-cost born by active funds. In particular, we establish a prima facie case for using tax credits to support active funds and enhance their market share. We discuss two types of tax credits: effort based tax credits and result-based tax credits. The use of targeted tax credits has four principal advantages over competing proposals. Effort based tax credits would be granted whenever an active funds undertake prespecified 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.
Our proposal has three potential advantages over competing proposals 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. Second, our proposal has the potential to create a virtuous financial cycle: the expected increase in tax revenues from the improved performance of firms generated by the tax should far surpass the cost of providing the credits. Third and 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.
Libson, Adi and Parchomovsky, Gideon, "Reversing the Fortunes of Active Funds" (2020). Faculty Scholarship at Penn Law. 2131.
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