Proposal to Adjust Tax Treatment of Mutual Funds Improves Neutrality in the Tax Code

Investment in American financial markets is a key part of the country’s long-term economic trajectory. The taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. treatment of investment impacts after-tax returns to saving and influences how Americans choose to invest, which can act as a barrier to domestic investment.

The Generating Retirement Ownership Through Long-Term Holding (GROWTH) Act, proposed in both chambers of Congress by Sen. John Cornyn (R-TX) and Rep. Beth Van Duyne (R-TX) this session, would make the tax treatment of investment funds more consistent and improve the tax treatment of saving in the US by allowing investors to defer tax on qualifying reinvested capital gains distributions until they sell their fund shares.

Mutual funds and exchange-traded funds (ETFs) are subject to the same tax rules as regulated investment companies (RICs). However, these two types of funds operate and process redemptions differently, which can produce different tax outcomes for shareholders.

For example, consider a conventional mutual fund that owns a stock with an underlying cost basis of $20 and a value of $100. A shareholder who redeems $100 in mutual fund shares may require the fund to sell $100 in underlying stock to pay the shareholder out, realizing an $80 capital gain. The net capital gain is distributed to the fund shareholder and not taxed within the fund itself, which means remaining shareholders owe capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment.  even though they did not sell any of their mutual fund shares.

Contrast this with an ETF.  Retail ETF shareholders sell their shares to other investors on secondary markets rather than directly redeeming them from the fund. Authorized participants can exchange blocks of ETF shares when they are redeemed from the fund for a set of underlying securities. These in-kind redemptions do not trigger capital gains realizations that would otherwise be distributed to remaining shareholders.

As a result, an investor can own virtually the same portfolio holdings and earn the same investment return but have different current tax liabilities depending on whether the fund is a mutual fund or an ETF.

Investors in both funds must pay capital gains tax upon sale of their fund shares, but mutual fund investors can face capital gains tax liability even while holding their positions. This can lead to different after-tax returns on investments depending on the underlying fund type. This has real-world consequences, as the average capital gains distributions are markedly higher for mutual funds than ETFs.

The GROWTH Act would defer recognition of qualifying reinvested capital gains until investors sell their fund shares, narrowing the difference in the timing of capital gains taxation between mutual funds and ETF shareholders in practice. Dividend and interest income would continue to be taxed as under current law.

From a neutrality perspective, the tax code should be designed such that investors make decisions about underlying investments and fund vehicles on the basis of the economic merits and not for tax purposes.

We estimate the GROWTH Act proposal would reduce federal revenue by $37.7 billion from 2027 to 2036 on a conventional basis. Similar to other proposed timing changes in the tax code, this cost is front-loaded as reinvested amounts previously subject to capital gains tax qualify for deferral, but no deferred amounts have been sold yet.

The net cost drops as deferred amounts are sold over time, leading to a lower steady-state cost just above $1 billion per year in the latter part of the budget window (see Model Notes below for more modeling details). The proposal would incur a net long-run cost to the federal government, and the annual revenue loss falls substantially as prior deferred gains are recognized.

Table 1. Conventional Revenue Effects of the GROWTH Act Mutual Fund Capital Gains Deferral, Billions of Dollars, 2027-2036

Year	2027	2028	2029	2030	2031	2032	2033	2034	2035	2036	2027-2036
GROWTH Act	-$14.1	-$9.8	-$6.2	-$2.9	-$0.1	-$0.5	-$0.8	-$1.0	-$1.1	-$1.3	-$37.7

Source: Tax Foundation General Equilibrium Model, September 2026.

In the long run, the conventional revenue cost may be somewhat smaller than the scored estimate because reinvested returns that make up deferred tax liability can themselves compound and be subject to tax. This effect was not included in the conventional revenue estimate.

Distributionally, the GROWTH Act would increase after-tax incomes by 0.1 percent on average in 2027. By 2036, the change in tax liabilities is smaller, leading to an increase of less than 0.05 percent in after-tax incomes across the income spectrum.

Table 2. Conventional Distributional Effects of the GROWTH Act (Percent Change in After-Tax Market Income)

Note: Market income includes adjusted gross incomeFor individuals, gross income is the total of all income received from any source before taxes or deductions. It includes wages, salaries, tips, interest, dividends, capital gains, rental income, alimony, pensions, and other forms of income. For businesses, gross income (or gross profit) is the sum of total receipts or sales minus the cost of goods sold (COGS)—the direct costs of producing goods (AGI) plus 1) tax-exempt interest, 2) non-taxable Social Security income, 3) the employer share of payroll taxes, 4) imputed corporate tax liability, 5) employer-sponsored health insurance and other fringe benefits, 6) taxpayers’ imputed contributions to defined-contribution pension plans. Market income levels are adjusted for the number of exemptions reported on each return to make tax units more comparable. After-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize their earnings. is market income less: individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source, corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax., payroll taxes, estate and gift taxA gift tax is a tax on the transfer of property by a living individual, without payment or a valuable exchange in return. The donor, not the recipient of the gift, is typically liable for the tax., customs duties, and excise taxes. Tax Units with negative market income and non-filers are excluded from the percentile groups but included in the totals.
Source: Tax Foundation General Equilibrium Model, September 2026.

By increasing the after-tax returns to saving, the GROWTH Act would also increase long-run gross national product (GNP), a measure of income American residents earn. The net economic impact of the proposal would depend on how the revenue loss is financed. For example, if it were financed through additional federal borrowing, higher debt would increase payments to foreign investors, offsetting some of the increase in American incomes.

The GROWTH Act would improve horizontal equity and neutrality in the tax code by ensuring identically situated investors within both mutual funds and ETFs face similar tax liability. But like all proposals, there are trade-offs.

By expanding the scope of deferral within the individual income tax, the proposal would encourage taxpayers to slow down their pace of capital gains realizations for tax purposes. This “lock-in” effect can prevent capital from being reallocated to more productive uses in the economy. The proposal’s proposed rule that prevents taxpayers from avoiding tax altogether via step-up in basisThe step-up in basis provision adjusts the value, or “cost basis,” of an inherited asset (stocks, bonds, real estate, etc.) when it is passed on, after death. This eliminates the capital gains tax owed by the recipient, reducing the heir’s tax liability. The cost basis receives a “step-up” to its fair market value, or the price at which the good would be sold or purchased in a fair marke limits this incentive, however.

On balance, the GROWTH Act would be a targeted improvement in tax neutrality, though larger reforms to the tax treatment of saving and investment would remove broader distortions in the taxation of capital gains. Ideally, the tax code should play a smaller role in determining how taxpayers invest and which fund they choose.

Modeling Notes

We used data from the IRS public use file (PUF) and statistics of income (SOI) to estimate applicable capital gains distributions reported directly on Form 1040 and imputed Schedule D distributions, projected forward for each year of the budget window. We calculate the value of net deferral (deferred minus sold) as a share of distributions to remove from each filer’s baseline distributions in simulation.

From there, the model calculates interactions with distributions for effects on adjusted gross income, the net investment income tax (NIIT), the alternative minimum tax (AMT), tax credits and phaseouts, and the payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue., among other interactions within the individual tax calculator. The calculator also applies the $3,000 net capital loss deduction limit.

We calculate holding period cohort on a pro rata realization basis for qualifying investments, which is anchored to IRS asset holding period data. We assume pro rata realization is enforced identically to the proposed statute, as the revenue estimate cost may increase if enforcement or the underlying proposal design changes.

We measured reinvestment rates of about 96 percent and a mutual fund share of combined mutual fund and REIT capital gains amounts of 93.3 percent using data from the Investment Company Institute.

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