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Senate tax reform should promote free market principles for investors

Senate tax reform should promote free market principles for investors
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Tax reform that simplifies the tax code and spurs economic growth is a good idea. Unfortunately, the legislation pending in the Senate contains a little noticed change affecting individual investors that moves reform in the opposite direction. Few things are more fundamental in a free market economy than for people to have the ability to dispose of their investments when and how they wish. Yet the Senate bill would end that basic financial freedom for individual owners of securities, mutual fund shares and highly popular exchange-traded funds (ETFs).

That’s plain wrong, almost un-American, and should be dropped from tax reform. To raise $2.4 billion in revenue over 10 years, the Senate bill would bar individuals from specifying the securities they sell. Instead, investors would be forced to sell their stocks, mutual funds and ETFs in which they hold multiple positions in the order in which they bought them. Oddly, this proposed “first in, first out” (FIFO) rule wouldn’t apply to managers of mutual funds, ETFs and other “regulated investment companies.”

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These professionals could continue to specify exactly what they sell, while individual investors could not. That’s unfair. Lawmakers are desperate to raise extra revenue to finance lower tax rates, a major aim of reform. Senate staffers seem to be betting that such an arcane rule as this won’t create an outcry. But they could be mistaken because millions of American investors would lose in the bargain.

Consider the case of a retiree who has invested in company stock over a 30-year career. That person’s initial investments have probably appreciated far more than recent purchases. Today, the retiree can sell his or her shares selected in a fashion that minimizes taxable gains or for any other reason. The Senate bill would end that flexibility and force the retiree first to take the oldest and probably largest gains into income and subject them to tax. More tax means less money for retirement.

Besides being coercive and unfair on its face, the proposal would hurt middle income investors more than high net worth individuals. The reason: The wealthy usually have more kinds of assets to liquidate than those who are less well off. Real estate, art, other collectibles and holdings of private companies aren’t covered in the Senate bill.

Markets are supposed to promote growth by allocating capital efficiently. Mandating FIFO would undermine this benefit by perversely causing investment decisions to be based increasingly on tax implications. For example, FIFO would encourage an owner of successful Stock A to buy Stock B rather than buying more of Stock A. Why? Stock A, when sold, would result in greater tax liability than Stock B. That’s the reverse of what tax reform is supposed to encourage.

Mandatory FIFO would also harm unsophisticated investors and reduce the advantages that average investors can now get from helpful and widely available technology such as robo advisers and wealth management accounts. Administering a mandatory FIFO system would be a nightmare. Since 2011, brokers have been required to track customer purchases of securities and to report to customers and the Internal Revenue Service the cost basis and holding periods of securities sold. Brokers don’t typically have records of customer purchases before 2011.

To implement FIFO, brokers would need access to all of a customer’s purchase information for any stock that is sold to accurately report cost basis and holding period. Gathering old records from boxes and putting the data into broker reporting systems won’t be easy. It certainly can’t be done by the Senate’s proposed implementation date of January 2018.

Rather than supporting the objectives of tax reform to create a simpler, fairer tax code built for growth, mandating FIFO would do the opposite. It would stymie economic growth by creating new barriers to efficient capital formation and complicate the lives of millions of American investors. The provision should be removed before it passes in the Senate and becomes the law of the land.

Thomas E. Faust, Jr. is chairman and chief executive officer of Eaton Vance Corporation, an investment management company based in Boston.