Summary: The proposal raises less than 6% of the potential revenue, does nothing to create a level playing field nor does it insure fair treatment of all tax payers. The measure’s legislative history indicates senators understand the FIFO tax proposal hurts financial markets by reducing liquidity. In sum, the measure leaves much to be desired. Congress needs to give serious consideration to other revenue raising proposals.
Put simply: This proposal restricts inventory accounting methods by type of legal entity.
An analogy demonstrates the confounding “logic” of the proposed tax law change. Imagine two firms import and sell Japanese products, paying prices that change throughout each year with fluctuations in the $/¥ rate. For simplicity, each firm’s taxable profit is the difference between the varying import cost and selling price. One firm is a partnership while the other a corporation. Now imagine a tax law change forces the partnership to use FIFO while allowing the corporation to pick whatever method yields the lowest taxable profit.
That’s the upshot of the Senate’s proposal: It allows two entity types (Mutual funds and ETFs) a full range of accounting methods as they sell shares while forcing a third entity type (Separately Managed Account or SMA) to use FIFO exclusively.
What might the Senate hope to accomplish in restricting SMA’s tax-accounting methods? How well does the FIFO rule serve each goal?
Purpose 1: Raise revenues
If the goal is raising revenues, applying the FIFO restriction to all three entities would collect 19 times more revenue than the current proposal because mutual funds and ETFs hold 19x the assets of SMAs. If a FIFO-for-all rule raises “too much” revenue, it’s straightforward to modify the proposal and cap the amount of tax due.
Purpose 2: Level a tilted playing field
The playing field is level because individual taxpayers pay virtually all taxes on capital gains realized in ETFs, Mutual Funds and SMA’s.
Purpose 3: Equalize the treatment of income among various taxpayers
Treating each tax payer “fairly” is an important tax policy goal. It’s not clear how taxpayer equity benefits from changing tax accounting for one of the three legal entities.
Purpose 4: Insure the functioning of financial markets
By forcing some investors to use FIFO, the proposal removes a portion of their shares for sale. Changing SMA investors’ tax accounting eliminates some of their loss-harvesting opportunities, reduces their account turnover and trims the shares they supply to the market. Shrinking the number of shares to sell (all else equal) reduces market liquidity.
The legislators as much as admitted the FIFO rule hurts market liquidity when they exempted Mutual Funds and ETFs from the FIFO accounting change. The senators exempted “registered investment companies” after they realized a FIFO-for-all policy would significantly erode liquidity; reducing the number of shares offered for sale by Mutual Funds, ETFs as well as SMA’s.
Objectives achieved: 0 for 4
In sum, the proposed tax accounting change for SMA’s is at best confounding and at worst bad policy; needlessly singling out holders of one one account type and negatively impacting market liquidity.
Better options available?
One wonders if members of Congress will choose to die on this hill or select other tax code changes raising similar revenue, treating each taxpayer “fairly” and promoting (rather than impairing) the functioning of securities markets.
*Note: “One of the tax law changes proposed in the Senate bill, but not the House bill, would require investors to use a first in, first out (FIFO) accounting methodology for tax lots when calculating capital gains tax.” “…The FIFO requirement seems to apply to all vehicles except for trading within Registered Investment Companies (mutual funds).” See: Parametric Portfolio Associates Link
 Under the Senate’s “Tax Cuts and Jobs Act” of 2017
 First In First Out: calculates cost using the oldest items first.Continue reading