It’s After Tax Returns That Count
When is a 2.5 per cent return better than a 10 per cent return? Some people might say that the 2.5 per cent return is better because it can be earned without taking on the extra risk necessary to generate the 10 per cent return.
However, this would not be the correct answer because it requires a subjective judgement to be made and is therefore open to interpretation. Those who prefer lower risk may be content to receive the 2.5 per cent return and would therefore consider it better. Those who are willing to endure volatility in the value of their capital or the potential for loss in exchange for a higher return would not agree that this is the better outcome.
Neither person is right or wrong because it depends on their own unique circumstances and their personal opinion. At best all that can be said is that an investment that produces the higher rate of return for each unit of risk taken on is a more efficient and thus more desirable investment.
The answer to the brainteaser of why a 2.5 per cent return is sometimes better than a 10 per cent return requires some additional information to be provided. Let’s say that you deposit $10,000 into a bank account, which earns 2.5 per cent per annum ($250) and that the underlying inflation rate measured by the consumer price index (CPI) is 1 per cent.
This means that in real (inflation adjusted terms) you have made 1.5 per cent or $150 (ignoring tax) over the course of the year, because you now need $10,100 to purchase the same goods and services that cost only $10,000 at the start of the period. So, in this example saving your hard-earned money has increased the available spending power by a small margin ($150) over the period of 12 months.
This assumes that the changes in the prices of the basket of goods and services that make up the CPI is representative of a person’s spending habits, which is of course a very broad generalization but it serves to illustrate the point.
During the 1970s and 1980s consumers experienced much higher levels of inflation and correspondingly higher interest returns on their bank deposits than those prevailing today. A typical example might be if your $10,000 bank deposit was earning 10 per cent ($1000) whilst the underlying inflation rate was 9 per cent. In this case your purchasing power will have increased by only 1 per cent or $100 ($1000 minus $900).
This simple analysis answers the conundrum of when is a 2.5 per cent return better than a 10 per cent return? When the nominal return is 2.5 per cent but the real return is 1.5 per cent this is better than receiving a nominal return of 10 per cent that translates into a real return of only 1 per cent. What matters is the real premium (after inflation) not the nominal premium. What also matters is the after-tax return, which I have conveniently ignored in the above example to keep the analysis simple. Now let us consider what impact income tax has on the results assuming a 32.5 per cent income tax rate.
Under the Income Tax Assessment Act earnings are subject to tax on the nominal income received rather than on the real income that is earned after inflation. This is just one of many weaknesses in the design of Australia’s tax system.
Referring to the above examples this means that a 2.5 per cent return reduces to 1.70 per cent ($170) after tax and a 10 per cent return produces only 6.75 per cent ($675) after tax. In real terms, this means that the profit is only $70 ($170 minus $100) in the first example when inflation is 1 per cent.
The after tax position is even worse in a high inflation environment. In real terms the profit of $675 is transformed into a loss of $225 ($675 minus $900) after adjusting for an inflation rate of 9 per cent. Put simply, a real after tax return of 0.7 per cent is clearly better than a loss of 2.25 per cent.
When comparing investments investors need to consider not only the level of risk that they are being exposed to but also whether the rewards after inflation and taxation truly justify the choice of one investment over another.