Tuesday, 7 December 2010

How Taxes Increase Inflation's Effect as a Return Killer

Income tax reduces investment returns. Inflation does too. Together they enhance each other's effect in quite dramatic fashion that surprised me when I did some simple example tables.

First, to be a little technical but more precise, whereas the rule of thumb to figure real returns net of inflation is to take a nominal return and subtract inflation, the more accurate formula divides (1 + nominal return) by (1 + inflation) as Wikipedia explains in the article on Inflation Tax. Our calculations below use the precise formula. When inflation is low the difference between the approximation and the precise formula is very small but at higher returns and inflation rates, the difference can be substantial, which comes out in the tables below.

Here is the first table (click to see it large). Observe that:

  1. Taxes make the investor a net loser even when nominal returns equal inflation. The yellow highlighted cells on the diagonal show nominal return equal to the inflation rate. In every cell except where both are zero, taxes on the nominal return eat up part of the inflation compensation. The higher the inflation, the worse it gets and the more taxes reduce returns. As we see sliding down towards the right e.g. when both nominal returns and inflation are 8%, someone at the 40% tax rate of this table actually loses 3.4%!
  2. Taxes can result in negative real after-tax returns even when nominal returns exceed inflation and again it gets worse the higher the inflation rate e.g. a 13% nominal return would not be enough to make a net gain when inflation is 8% in the bottom right corner. Another of looking at this is to note case A) (the cells highlighted with a blue border), where a combination of nominal pre-tax 4.47% return and 0% inflation equals the net return of the much wider 6% spread combo of 8% nominal and 2% inflation.
  3. Note how the GIC-zone of 1 to 3% current rates (per Canoe Money) within Bank of Canada target 1% to 3% inflation is pretty well entirely in negative red returns for a 40% tax rate. And it's true for more or less the whole gamut of tax rates as our other tables for 46% (posted below) and 25% (not posted here but I did the numbers) tax rates show.
  4. Net returns are higher in low inflation even when pre-tax real (after inflation) returns are the same e.g. in case B) the real pre-tax return of 5.88% equals the 8%-2% combo but the 5.88% - 0% combo would produce 3.53% real after-tax versus only 2.68%.
The second table shows the effects at the highest Ontario marginal tax rates of 46.21%.

  1. Net returns are even worse at the higher tax rate, not a surprise, as there is more red / negative returns and lower numbers throughout the table.
  2. The spreads necessary to make money are even more accentuated at the higher tax rate - it takes more difference between nominal returns and inflation to compensate when the tax rate is higher e.g. whereas at 40% tax, the 6%-0% combo could be equalled by the 9.58%-2% combo, at 46% it takes 10% nominal to be equal at 2% inflation (case E) the green framed cells).
What defences and counters are there? Apart from praying and maybe doing a little political lobbying to have government set even lower inflation targets (noting however, that when the investor loses from taxes and inflation, the government is a big beneficiary), the basic strategy is to defer taxes as long as possible:
  • Though one cannot escape the effects entirely with registered accounts since taxes must eventually paid upon withdrawal, using registered accounts for tax deferral becomes even more important the more inflation rises;
  • In taxable accounts, trade less to avoid realizing capital gains, buy and hold with index funds (on page 71 of Jeremy Siegel's Stocks for the Long Run that shows how the inflation tax effect on capital gains lessens progressively with longer and longer holding periods; hat tip to Siegel as well since that is where the idea for this post came from).
  • Pick funds or ETFs for taxable accounts like the new Horizons BetaPro S&P/TSX 60 Index ETF (symbol: HXT) (reviewed here) that produces no immediate taxable distributions.
  • In taxable accounts, seek returns from lower tax rate types of income - the lowest being dividends, then capital gains, with interest the last choice (Canadian real return bonds have the unpleasant feature that the inflation adjustment component is just as taxable as the real return portion, as Bylo Selhi notes here)
It used to be that only death and taxes were inevitable. Unfortunately, inflation is too nowadays, so we need to be aware of its toxic effects.

1 comment:

Michael James said...

Good post. I've tried to explain this to people who yearn for the good old days when Canada Savings Bonds paid high interest, but few people seem to understand how inflation plus taxes killed the returns.

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