Impact of Taxes and Inflation on Investment

A Realistic View of Returns

1. Computation of Post-Tax Return

• Explanation: Tax on investment gains can significantly reduce the actual return received. Calculating the post-tax return is essential for making informed investment decisions.

• Formula (as provided):

  Rafter tax = Rbefore tax × (1 - Tax Rate)
  

• Components Explained:

  • Rafter tax: Return after taxes. This is the return that the investor truly gets to keep.

  • Rbefore tax: Return before taxes. This is also the stated returns of an instrument.

  • Tax Rate: The applicable tax rate, expressed as a decimal (e.g., 30% tax rate = 0.30).

• Utility (as provided):

  • Used to evaluate after-tax profitability which are the most representative of the earnings you will be likely to receive.

• Elaboration

  • It is particularly critical to accurately assess tax liability. Do not just assume your profits can be taxed at 30%.
  • Different forms of income can be taxed at higher or lower rates. Be specific.
  • This calculation can be used with most, if not all, other analyses of returns.

• Limitations:

  • Doesn't account for tax-deferred or tax-exempt accounts: In tax-advantaged accounts (e.g., 401(k)s, Roth IRAs), taxes may not be due until withdrawal, or may be entirely tax-free.
  • Doesn't account for changing tax rules: Tax laws can change, impacting the tax rate applied to investment income.
  • Doesn't account for tax bracket implications.

• Example (as provided):

  • If a bond yields 10% and the tax rate is 30%, post-tax return = 10% × (1-0.30) = 7%. You would actually be left with 7% after taxes.

2. Computation of Real Return (Adjusted for Inflation)

• Explanation: Inflation erodes the purchasing power of investment returns. Calculating the real return accounts for inflation, providing a more accurate measure of investment success.

• Formula (Fisher Equation, as provided):

  Rreal = (1 + Rnominal) / (1 + Inflation Rate) - 1
  

• Components Explained:

  • Rreal: Real return (inflation-adjusted return).
  • Rnominal: Nominal return (stated return).
  • Inflation Rate: The annual inflation rate, expressed as a decimal (e.g., 3% inflation rate = 0.03).

• Utility (as provided):

  • Used to understand the true increase in purchasing power resulting from the investment.

• Elaboration

  • Like the other equations, apply great specificity to the numbers you provide.
  • If one month sees a rapid spike in inflation, that specific month and investment should be used.

• Limitations:

  • Assumes constant inflation: Inflation rates can fluctuate over time.

  • Does not account for taxes: Real return does not consider the effect of taxes, which can further reduce purchasing power.

• Example (as provided):

  • If nominal return is 8% and inflation is 3%, then: Real return = (1.08 / 1.03) - 1 = 4.85%
  • In this scenario, 4.85% is the true increase in income that you actually can use to buy more.

Conclusion

Risk-return analysis, inflation and taxes are crucial to portfolio construction. This is because:

• They drastically alter expected profits
• They also drastically alter investment strategies, as some high tax activities or extremely risky activities are only worthwhile because the overall returns are likely to be superior.