R11 Taxes and Private Wealth Management in a Global Context

Question 1

R11

General Income Tax Regimes

Common Progressive

Answer 1

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

Question 2

R11

General Income Tax Regimes

Heavy CGT

Heavy Interest

Heavy Dividend

Answer 2

Same as Common Progressive but with CGT / Interest / Dividend taxed at ordinary rates respectively.

Question 3

R11

General Income Tax Regimes

Light Capital Gain Tax

Answer 3

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

Question 4

R11

General Income Tax Regimes

Flat and Light

Answer 4

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

Question 5

R11

General Income Tax Regimes

Flat and Heavy

Answer 5

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

Question 6

R11

Returns-Based Taxes: Accrual Taxes on Interest and Dividends

Answer 6

FVIF_i = [1 + r(1 – t_i)]ⁿ 

• Tax Drag = gain wih no tax - gain after taxes
• Tax Drag % = tax drag / gain after taxes

Question 7

R11

Returns-Based Taxes: Deferred Capital Gains

Answer 7

FVIF_cg = (1 + r)ⁿ(1 – t_cg) + t_cg  

Question 8

R11

Taxes: Cost Basis

Answer 8

FVIF_cgb = (1 + r)ⁿ(1 – t_cg) + t_cgB  

Question 9

R11

Wealth-Based Taxes

Answer 9

FVIF_w = [(1 + r)(1 – t_w)]ⁿ  

Question 10

R11

Blended Taxing Environments

Answer 10

Annual return after realized taxes:

r* = r(1 – p_iti – p_dt_d – p_cgt_cg)

Effective capital gains tax rate:

T* = t_cg(1 – p_i – p_d – p_cg)/(1 – p_it_i – p_dt_d – p_cgt_cg)

P= return

Future after-tax accumulation for each unit of currency in a taxable portfolio:

FVIF_Taxable = (1 + r*)ⁿ(1 – T*) + T* – (1 – B)t_cg

Question 11

R11

Accrual Equivalent Returns

Answer 11

Portifolio Value(1 + R_AE)ⁿ = after-tax accumulation

Question 12

R11

Accrual Equivalent Tax Rates

Answer 12

r(1 – T_AE) = R_AE

Question 13

R11

Tax-Deferred Accounts

Answer 13

FVIF_TDA = (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.

Question 14

R11

Tax-Exempt Accounts

Answer 14

FVIF_TaxEx = (1 + r)ⁿ  

• Tax-exempt accounts do not allow tax-deductible contributions, but allow tax-exempt accumulation of returns even when funds are withdrawn.

Question 15

R11

Taxes and Investment Risk

Answer 15

After-tax standard deviation:

σ(1 − t_i)

• 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.

Question 16

R11

Tax Drag

Answer 16

• 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

Question 17

R11

Tax Loss Havesting

Answer 17

• 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.

Question 18

R11

Tax Alpha

Answer 18

• 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.

Question 19

R11

highest-in, first-out (HIFO) tax lot accounting

Answer 19

• 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)

Question 20

R11

Conclusions for Accural Taxes

Answer 20

1. Over a longer time horizon: Tax Drag % > Current Tax Rate
2. Over a longer time horizon: Tax Drag $ and Tax Drag % increases
3. If pre-tax return increases: Tax Drag $ and Tax Drag % increases
4. If time horizon and pre-tax return increases: Tax Drag $ and Tax Drag % increases even more

Question 21

R11

Conclusions for Deferred Capital Gains

Answer 21

1. The is no lost compounding of return (compared to accural taxation). All taxes are paid at the end of the time horizon.
2. 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.
3. 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

Question 22

R11

Conclusions for Wealth Based Taxes

Answer 22

1. Wealth based taxes apply to total value not just return. So they are more burdensome than other taxes.
2. As the time horizon increases both tax drag $ and tax drag % increase due to the loss of pre-tax compounding
3. As the rate of return increases the tax drag $ increases but the tax drag % decreases.

Question 23

EMH: Anomalies

Answer 23

1. Fundamental Anomalies. Value and Growth investing - but are they a function of incomplete models of asset pricing?
2. Technical Anomalies. Moving averages and Trading Range break (Support and Resistance). Disputed.
3. Calendar Anomalies. The January Effect and turn-of-the-month effect.

Question 24

Behavioral Approach to Consumption and Savings

Answer 24

• 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.

Question 25

Behavioral Approach to Asset Pricing

Answer 25

• Stochastic discount factor-based (SDF-based) asset pricing model
• Model focuses on market sentiment as a major determinant of asset pricing,
• Sentiment pertains to erroneous, subjectively determined beliefs.

Question 26

Behavioral Portfolio Theory

Answer 26

• BPT uses a probability-weighting function rather than the real probability distribution used in Markowitz’s portfolio theory
• Investors construct their portfolios in layers and expectations of returns and attitudes toward risk vary between the layers.
• Construction is primarily a function of five factors:

1. Allocation to different layers depends on investor goals and the importance assigned to each goal
2. Allocation of funds within a layer to specific assets will depend on the goal set for the layer
3. Number of assets chosen for a layer depends on the shape of the investor’s utility function.
4. Concentrated positions in some securities may occur if investors believe they have an informational advantage with respect to the securities
5. Investors reluctant to realize losses may hold higher amounts of cash so that they do not have to meet liquidity needs by selling assets that may be in a loss position

Question 27

Adaptive Markets Hypothesis

Answer 27

(AMH) A hypothesis that applies principles of evolution—such as competition, adaptation, and natural selection—to financial markets in an attempt to reconcile efficient market theories with behavioral alternatives.

• The AMH is a revised version of the EMH that considers bounded rationality, satisficing, and evolutionary principles
• Under the AMH, individuals act in their own self-interest, make mistakes, and learn and adapt; competition motivates adaptation and innovation; and natural selection and evolution determine market dynamics

Question 28

Five implications of the AMH

Answer 28

1. The relationship between risk and reward varies over time (risk premiums change over time) because of changes in risk preferences and such other factors as changes in the competitive environment
2. Active management can add value by exploiting arbitrage opportunities
3. Any particular investment strategy will not consistently do well but will have periods of superior and inferior performance
4. The ability to adapt and innovate is critical for survival
5. Survival is the essential objectiv

Question 29

Bounded Rationality

Answer 29

• The notion that people have informational and cognitive limitations when making decisions and do not necessarily optimize when arriving at their decisions.
• The term satisfice combines “satisfy” and “suffice”
• Instead of looking at every alternative, people set constraints as to what will satisfy their needs
• Decision makers may use heuristics to guide their search. An example of heuristics is means-ends analysis.
• Portfolio decisions are based on a limited set of factors, such as economic indicators, deemed most important to the end goal

Question 30

Prospect Theory

Answer 30

• Prospect theory considers how prospects (alternatives) are perceived based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted.
• Prospect theory assigns value to gains and losses (changes in wealth) rather than to final wealth
• There are two phases to making a choice: an early phase in which prospects are framed (or edited) and a subsequent phase in which prospects are evaluated and chosen
• Depending on the number of prospects, there may be up to six operations in the editing process: codification, combination, segregation, cancellation, simplification, and detection of dominance.
• People are risk-averse when there is a moderate to high probability of gains or a low probability of losses; they are risk-seeking when there is a low probability of gains or a high probability of losses.

Question 31

Rational Economic Man

Answer 31

• Traditional Finance Perspective
• Principles of perfect rationality, perfect self-interest, and perfect information govern REM’s economic decisions.
• Those who challenge REM do so by attacking the basic assumptions of perfect information, perfect rationality, and perfect self-interest.

Question 32

Utility Theory

Answer 32

• Traditional Finance Perspective
• Generally assumes that individuals are risk-averse
• Theory whereby people maximize the present value of utility subject to a present value budget constraint.
• May be thought of as the level of relative satisfaction received from the consumption of goods and services
• Basic axioms of utility theory: Completeness, Transitivity, Independence , Continuity
• If the individual’s decision making satisfies the four axioms, the individual is said to be rational
• The rational decision maker, given new information, is assumed to update beliefs about probabilities according to Bayes’ formula

Question 33

EMH

Answer 33

• Weak Form - All past market price and volume data are fully reflected in securities’ prices. Technical analysis will not generate excess returns
• Semi-Strong Form - all publicly available information, past and present, is fully reflected in securities’ prices. Technical and fundamental analyses will not generate excess returns
• Strong-form - assumes that all information, public and private, is fully reflected in securities’ prices. Even insider information will not generate excess returns.