R11 Taxes and Private Wealth Management in a Global Context Flashcards
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General Income Tax Regimes
Common Progressive
Ordinary Tax Rate Structure:
Progressive
Interest Income:
Some interest taxed at favorable rates or exempt
Dividends:
Some dividends taxed at favorable rates or exempt
Capital Gains:
Some capital gains taxed favorably or exempt
Examples:
UK, US, France
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General Income Tax Regimes
Heavy CGT
Heavy Interest
Heavy Dividend
Same as Common Progressive but with CGT / Interest / Dividend taxed at ordinary rates respectively.
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General Income Tax Regimes
Light Capital Gain Tax
Ordinary Tax Rate Structure:
Progressive
Interest Income:
Taxed at ordinary rates
Dividends:
Taxed at ordinary rates
Capital Gains:
Some capital gains taxed favorably or exempt
Examples:
Australia, Spain, Norway
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General Income Tax Regimes
Flat and Light
Ordinary Tax Rate Structure:
Flat
Interest Income:
Some interest income taxed favorably or exempt
Dividends:
Some dividends taxed favorably or exempt
Capital Gains:
Some capital gains taxed favorably or exempt
Examples:
Russia, Saudi Arabia
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General Income Tax Regimes
Flat and Heavy
Ordinary Tax Rate Structure:
Flat
Interest Income:
Some interest income taxed favorably or exempt
Dividends:
Taxed at ordinary rates
Capital Gains:
Taxed at ordinary rates
Examples:
Ukraine
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Returns-Based Taxes: Accrual Taxes on Interest and Dividends
FVIFi = [1 + r(1 – ti)]n
- Tax Drag = gain wih no tax - gain after taxes
- Tax Drag % = tax drag / gain after taxes
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Returns-Based Taxes: Deferred Capital Gains
FVIFcg = (1 + r)n(1 – tcg) + tcg
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Taxes: Cost Basis
FVIFcgb = (1 + r)n(1 – tcg) + tcgB
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Wealth-Based Taxes
FVIFw = [(1 + r)(1 – tw)]n
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Blended Taxing Environments
Annual return after realized taxes:
r* = r(1 – piti – pdtd – pcgtcg)
Effective capital gains tax rate:
T* = tcg(1 – pi – pd – pcg)/(1 – piti – pdtd – pcgtcg)
P= return
Future after-tax accumulation for each unit of currency in a taxable portfolio:
FVIFTaxable = (1 + r*)n(1 – T*) + T* – (1 – B)tcg
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Accrual Equivalent Returns
Portifolio Value(1 + RAE)n = after-tax accumulation
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Accrual Equivalent Tax Rates
r(1 – TAE) = RAE
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Tax-Deferred Accounts
FVIFTDA = (1 + r)n(1 – Tn)
- Tax-deferred accounts allow tax-deductible contributions and/or tax-deferred accumulation of returns, but funds are taxed when withdrawn.
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Tax-Exempt Accounts
FVIFTaxEx = (1 + r)n
- Tax-exempt accounts do not allow tax-deductible contributions, but allow tax-exempt accumulation of returns even when funds are withdrawn.
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Taxes and Investment Risk
After-tax standard deviation:
σ(1 − ti)
- Taxes not only reduce an investor’s returns, but also absorb some investment risk
- By taxing investment returns, a taxing authority shares investment risk with the taxpayer. As a result, taxes can reduce investment risk.
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Tax Drag
- The negative effect of taxes on after-tax returns
- Tax drag on capital accumulation compounds over time when taxes are paid each year
- When taxes on gains are deferred until the end of the investment horizon, the tax rate equals the tax drag on capital accumulation
- Tax drag increases with the investment return and time horizon
- The difference between the accrual equivalent return and the taxable return is a measure of the tax drag imposed on a portfolio.
- An analogous way to measure tax drag is with the accrual equivalent tax rate
- Active management can create a tax drag
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Tax Loss Havesting
- Tax loss harvesting defers tax liabilities from current to subsequent periods and permits more after-tax capital to be invested in current periods.
- Selling a security at a loss and reinvesting the proceeds in a similar security effectively resets the cost basis to the lower market value, potentially increasing future tax liabilities.
- A subtle benefit of tax loss harvesting is that recognizing an already incurred loss for tax purposes increases the amount of net-of-tax money available for investment. Realizing a loss saves taxes in the current year, and this tax savings can be reinvested. This technique increases the amount of capital the investor can put to use.
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Tax Alpha
- The value created by using investment techniques that effectively manage tax liabilities (tax loss harvesting and HIFO) is sometimes called tax alpha
- Although cumulative tax alphas from tax loss harvesting increase over time, the annual tax alpha is largest in the early years and decreases through time as deferred gains are ultimately realized.The complementary strategies of tax loss harvesting and HIFO tax lot accounting have more potential value when securities have relatively high volatility, which creates larger gains and losses with which to work.
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highest-in, first-out (HIFO) tax lot accounting
- Depending on the tax system, investors may be allowed to sell the highest cost basis lots first, which defers realizing the tax liability associated with lots having a lower cost basis.
- Harvesting losses is not always an optimal strategy. For example, in cases where an investor is currently in a relatively low tax rate environment and will face higher tax rates on gains in a subsequent period (either because her tax bracket will increase or because tax rates generally are increasing)
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Conclusions for Accural Taxes
- Over a longer time horizon: Tax Drag % > Current Tax Rate
- Over a longer time horizon: Tax Drag $ and Tax Drag % increases
- If pre-tax return increases: Tax Drag $ and Tax Drag % increases
- If time horizon and pre-tax return increases: Tax Drag $ and Tax Drag % increases even more
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Conclusions for Deferred Capital Gains
- The is no lost compounding of return (compared to accural taxation). All taxes are paid at the end of the time horizon.
- As the time horizon and/or the rate if return increases the tax drag $ amount increases because the tax paid will be on a larger pre-tzx ending value.
- The tax drag % versus current (stated) tax rate depends on the basis:
- Tax Drag % = Tax Rate if B = 1
- Tax Drag % > Tax Rate if B < 1 because there is an additional gain subject to tax.
- Tax Drag % =< Tax Rate if B > 1 because the portion of the return earning during the period back to the cost basis is not taxed
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Conclusions for Wealth Based Taxes
- Wealth based taxes apply to total value not just return. So they are more burdensome than other taxes.
- As the time horizon increases both tax drag $ and tax drag % increase due to the loss of pre-tax compounding
- As the rate of return increases the tax drag $ increases but the tax drag % decreases.
EMH: Anomalies
- Fundamental Anomalies. Value and Growth investing - but are they a function of incomplete models of asset pricing?
- Technical Anomalies. Moving averages and Trading Range break (Support and Resistance). Disputed.
- Calendar Anomalies. The January Effect and turn-of-the-month effect.
Behavioral Approach to Consumption and Savings
- Incorporates self-control, mental accounting, and framing biases
- People classify their sources of wealth into three basic accounts: current income, currently owned assets, and the present value of future income
- Individuals are hypothesized to first spend current income, then to spend based on current assets, and finally to spend based on future income.