CHICAGO - By all estimations, the GROWTH Act is gaining momentum among lawmakers in Washington, but at least one high-ranking official said its proponents must answer some serious questions before it gets a shot at becoming a law in the months ahead.

A bipartisan bill introduced in the House of Representatives earlier this year by Paul Ryan (R-Wis.) and William Jefferson (D-La.), the GROWTH Act seeks to rewrite a broad capital gains tax that was enacted when mutual funds were an obscure investment vehicle for the rich and not the preferred retirement and educational savings choice of nearly 50% of all American households that they are today.

In short, U.S. Department of the Treasury Associate Tax Counsel Michael S. Novey asked: What makes the mutual fund industry so damn special?

"If the argument is that a particular [investment] vehicle merits treatment that differs materially and in a more favorable fashion from an arguably analogous way of investing, please show us why," Novey told attendees of the annual Investment Company Institute Tax & Accounting Conference, held here last week.

Under present law, which was written 60 years ago, mutual funds are required to annually distribute net capital gains. Those investors with taxable accounts are required to pay taxes on the capital gains distributions, even if they decide to automatically reinvest those gains directly back into the fund. The GROWTH Act, or the Generating Retirement Ownership Through Long-Term Holding Act of 2005, would allow mutual fund investors to defer the tax on all reinvested capital gains distributions until the shares are redeemed. This is consistent, the bill's proponents maintain, with the popular understanding that capital gains taxes are not due until you sell the investment. That is the way an investor who holds stock directly is taxed, proponents say.

"I see no valid reason why the tax treatment for funds should differ so widely from that for stocks," observed Russel Kinnel, director of mutual fund research at Chicago-based Morningstar.

In fact, Kinnel said in a recent research note, the "archaic" tax rule actually "encourages rapid trading rather than long-term investing, and it, in turn, is diminishing fund investors' returns."

Not surprisingly, the ICI is also a strong supporter of the legislation. Paul Schott Stevens, president of the Washington-based lobbyist, has called it one of the best ideas to come forward in recent years. "It would help smooth the path to long-term financial security for millions of Americans," he said.

"Right now, long-term capital gains distributed among mutual fund investors in taxable accounts are taxed every year, even if they are automatically invested," Stevens said at the annual ICI General Membership Meeting earlier this year. "The GROWTH Act would defer taxation until fund shares are sold. That keeps more retirement savings invested longer and growing longer by taxing income when it's withdrawn, not savings while they are being built up."

It's been estimated that more than 95% of mutual fund investors choose to automatically reinvest their capital gains back into the same mutual fund.

Bills like the GROWTH Act, however, are a dime a dozen among election-minded politicians in Washington. Similar proposals have come and gone over recent years, like swallows to Capistrano. But GROWTH Act backers in Chicago last week said this bill already has the support of 32 U.S. Representatives, just a fraction of the House's 435 members, but evidently noteworthy for the proposal's infancy. A bi-partisan version of the bill is expected on the floor of the U.S. Senate very soon, they said, probably shortly after lawmakers conclude Hurricane Katrina relief efforts.

Rep. Jerry Weller (R-Ill.) said in a keynote address that he's optimistic about the bill's future, due largely to 77 million Baby Boomer voters. "I'm a mutual fund investor, too" he said. "I see my statement, where the money goes. It just isn't fair."

And in perhaps the first public endorsement of the bill from a major industry player, Deanna J. Flores, senior counsel at the Valley Forge, Pa.-based fund shop Vanguard Group, said, "It really does make sense as a tool in the arsenal to create retirement security for Baby Boomers and other Americans as they move into retirement in the coming years."

But the Treasury Department's Novey warned proponents that they should brace themselves for a hefty dose of scrutiny from U.S. tax officials once the bill's debate eventually does get under way.

For starters, Novey said in a brief, devil's advocate address, GROWTH Act backers must demonstrate how mutual fund investors differ from direct investors, when on paper the only significant difference is that mutual fund investors have hired someone with investing expertise to make the investment decisions.

"Maybe," he said, "there are good public policy reasons why investment dollars should be steered to this particular investment vehicle. If that is your belief, please make it clearly and cogently to us."

And what about taxes consistent with other financial intermediaries, he asked.

"One of the things that is a tremendous source of complexity in our current tax law is that you have a wide range of financial intermediaries, each of which has its own idiosyncratic tax regime, all of which try to achieve approximately consistent tax results," Novey explained. "If you believe that the GROWTH Act would produce results that are consistent with direct investing, with investing through a trust, a state, or a REIT...if you think the GROWTH Act would enhance consistency with all these other ways of investing, then please make that argument to us. We need to hear it."

Or perhaps, Novey added, GROWTH Act proponents believe that reinvested capital gains should enjoy deferred taxation regardless of the form of the investment vehicle.

"There are some much bigger considerations kicking around, which would take this or a more comprehensive approach. If so, make that argument to us," Novey remarked.

Without taking Novey's bait completely, Keith Lawson, senior counsel with the ICI, replied that the key differentiator between mutual funds and other investment vehicles with an intermediary is that mutual funds are products that are purchased and, therefore, should only be taxed once.

"People need a bigger incentive to reinvest their capital gains," Lawson added. "And we're not talking about eliminating taxation, we're talking about deferral. And in the grand scheme of things, everything would even out in a way that the revenue estimated rules would work."

That, however, may ultimately be for Congress to decide.

(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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