Unintended (?) Consequences and the Endowment Tax

Paul Caron’s Tax Prof Blog’s regular feature on Tax Policy in the Trump Administration has a long, long list of entries today, including an article from the Wall Street Journal on university reactions to the increase in the endowment tax. As described more fully last week on this Blog, the current version of the OBBB appears to amend the existing endowment tax by increasing the number of schools subject to the tax as well as raising the rates incrementally based on the size of the endowment.

Here’s the crazy thing about taxpayers – and especially sophisticated taxpayers: turns out they are sensitive to tax changes!  Who knew!?

The Wall Street Journal article (sorry - behind paywall) talked to a number of university endowment officials about what investment changes the endowments might make to minimize the increased tax liabilities under an amended tax.  Not surprisingly, endowments are considering moves out of investments that would produce net investment income, especially short term gains. The article predicts that there would be a move from those hedge funds that frequently realize gains and into private equity investments that might have more controllable/predictable sources of realized income.  At the same time, the article talks about increased liquidity needs due to tax itself and other factors (such as having to fund discontinued grants and provide more financial aid), which leads to worries about lock-up issues. And as with most sophisticated investors, endowments will now need to factor tax efficiency into the choice of investments, which may override issues such as liquidity or volatility.

If we play through what the article’s predictions actually mean, I think we can anticipate that endowments will need to chase higher returns in the locked-up portion of the portfolio to make up for the parts of their portfolios that are going to underperform in the name of liquidity. Higher levels of risk and volatility seem to be in the future if an endowment wants to keep up with inflation. Higher costs of endowment management for tax sensitivity, and of course, the tax itself, will lead to lower amounts available for distributions to students, researchers, and operations.  None of this is particularly surprising, of course, leading one to wonder if these are unintended consequences or if they are exactly the point.

When I was ADAA, I had a little caution traffic sign on my desk that read “But is this good for students?”  I would lend my sign to the authors of this bill, but that would require one to think that the good of students has anything to do with this legislation.

With exasperation, eww