Session 03_Returns to Alternative Savings Vehicles

8/3/2019 Session 03_Returns to Alternative Savings Vehicles

1/18

Chapter

KeyWords/Outline

3

Returns to Alternative

Savings Vehicle


2/18

Slide 1-2

Distinguishing Alternative Savings Vehicles

Alternative savings vehicles are distinguished bytheir tax attributes:

Tax-deductibility of the investment: whether

deposits into the savings accounts give rise to animmediate tax deduction [tax-deductible or tax-nondeductible]

Frequency of taxation: the frequency with which

investment earnings are taxed [tax-deduction atsource, annual taxation, deferred taxation]

Applicable tax rate: the rate at which the investmentearnings are taxed [ordinary tax rate, special high

tax rate, or concessionary rate]


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Slide 1-3

Alternative Savings Vehicles(Intertemporally Constant Tax Rates)

SavingsVehicle

Tax-deductibility

of theinvestment

Frequencyof taxation

Applicabletax rate

After-tax accumulationper after-tax Tk. I

invested [F]

INo Annually Ordinary I

.[1+R

(1t)]n

II No Deferred Ordinary I.(1+R)n (1t)+t.I

III No Annually Capital gains I.[1+R(1tcg)]n

IVNo Deferred Capital gains I.(1+R)n (1t

cg

)+tcg

.I

V No Never Exempt I.(1+R)n

VI Yes Deferred Ordinary [I.(1t)].(1+R)n (1t)

or I.(1+R)n


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Slide 1-4


SavingsVehicle

Tax-deductibility

of investment


Applicabletax rate

Example inthe USA

I No Annually Ordinary Money Market Funds

II No Deferred Ordinary Single premium deferredannuity

III No Annually Capitalgains

Mutual Fund

IV No Deferred Capital

gains

Foreign corporations

V No Never Exempt Insurance Policy

VI Yes Deferred Ordinary Pension


5/18

Slide 1-5


SavingsVehicle

Tax-deductibility

of investment


Applicabletax rate

Example inBangladesh

I No Annually Ordinary Money Market Funds

II No Deferred Ordinary Term Securities [DefenseSavings Certificate]

III No Annually Capitalgains

-------***

IV No Deferred Capitalgains

Corporate Investment inShares

V No Never Exempt Insurance Policy

VI Yes Deferred Ordinary --------

***Income of the mutual fund of the person issuing such mutual fund is exempted u/p 30,Part A, 6th Sch.


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Slide 1-6


SavingsVehicle

Tax-deductibilityof investment

Frequency oftaxation

Applicabletax rate


III No Annually Capital gains ------- ***

***Reduced tax rate (5%-15%) for initial 5-6 years allowed to prescribed new industries

established between 1.7.2009 to 30.6.2012(videSRO No. 172-Ain/Aykar/2009, dt. 1.7.2009).[Tax Rates: 5% for first 2 years; 10% for next 2 years; 15% for next 1 year (industries in Dhaka andChittagong Divisions except for Rangamati, Bandarban and Khagrachari hill districts) and 5% for first 3years; 10% for next 3 years (industries in other areas)].

SavingsVehicle

Tax-deductibilityof investment

Frequency oftaxation

Applicabletax rate


VI Yes Deferred Ordinary --------***

*** Employers contributions towards Approved Pension Fund are tax-deductible [para 5(2), Part A, 1stSch of ITO]

Income of the Fund (interest, dividend or capital gains) are exempted from tax [u/p 5(1)]

Pension received by employee is exempted u/p 8, Part A, 6th Sch.


7/18


8/18

Slide 1-8


SavingsVehicle(USA)

After-tax rate ofreturn

I = Tk. 1 R = 7% t = 30% tcg = 15%

n=1 n=5 n=10 n=20 n=40 n=100

I [FI]1/n 1 4.90 4.90 4.90 4.90 4.90 4.90

II [FI]1/n 1 4.90 5.09 5.31 5.66 6.12 6.62

III [FI]1/n 1 5.95 5.95 5.95 5.95 5.95 5.95

IV [FI]

1/n

15.95 6.06 6.18 6.37 6.60 6.83

V [FI]1/n 1 7.00 7.00 7.00 7.00 7.00 7.00

VI [FI]1/n 1 7.00 7.00 7.00 7.00 7.00 7.00


9/18

Slide 1-9

Savings Vehicles I and II(Intertemporally Constant Tax Rates)

SavingsVehicle(USA)


invested [F]

I = Tk. 1 R = 7% t = 30% tcg = 15%

n=1 n=5 n=10 n=20 n=40 n=100

I I.[1+R(1t)]n 1.05 1.27 1.61 2.60 6.78 119.55

II I.(1+R)n (1t)+t.I 1.05 1.28 1.68 3.01 10.78 607.70

Comparison:

For investment horizons of only one period (n=1), Vehicle I andVehicle II are equivalent.

Except for n=1, the after-tax accumulation in Vehicle II alwaysexceeds that in Vehicle I.

The longer the holding period, the greater the difference in

accumulation.


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Slide 1-10

Savings Vehicles I and II(Intertemporally Constant Tax Rates)

SavingsVehicle(USA)

After-tax rate ofreturn

(r)

I = Tk. 1 R = 7% t = 30% tcg = 15%

n=1 n=5 n=10 n=20 n=40 n=100

I [FI]1/n 1 4.90 4.90 4.90 4.90 4.90 4.90

II [FI]1/n 1 4.90 5.09 5.31 5.66 6.12 6.62

Comparison:

All the after-tax annualized rates of return (r) are 4.9% in

Vehicle I. But these rates increase in Vehicle II with the number of

holding periods.

In fact, in case of Vehicle II, as the number of periods becomes large,the after-tax rate of return per period approaches the before tax rates

of return (R) of 7%.


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Slide 1-11

Savings Vehicles II and III(Intertemporally Constant Tax Rates)

SavingsVehicle(USA)


invested [F]

I = Tk. 1 R = 7% t = 30% tcg = 15%

n=1 n=5 n=10 n=20 n=40 n=100

II I.(1+R)n (1t)+t.I 1.05 1.28 1.68 3.01 10.78 607.70

III I.[1+R(1tcg)]n 1.06 1.34 1.78 3.1810.09

323.67

II After-tax rate ofreturn (r)

4.90 5.09 5.31 5.66 6.12 6.62

III After-tax rate of

return (r)

5.95 5.95 5.95 5.95 5.95 5.95

Comparison: Vehicle II may be more attractive than Vehicle III dependingon n and tcg. For example,

if tcg=0, Vehicle III always dominates Vehicle II, even for n=1

If 0


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Slide 1-12

Savings Vehicle IV(Intertemporally Constant Tax Rates)

SavingsVehicle

After-tax accumulation I = Tk. 1 R = 7% t = 30% tcg = 15%

n=1 n=5 n=10 n=20 n=40 n=100

I I.[1+R(1t)]n 1.05 1.27 1.61 2.60 6.78 119.55

II I.(1+R)n (1t)+t.I 1.05 1.28 1.68 3.01 10.78 607.70

III I.[1+R(1tcg)]n 1.06 1.34 1.78 3.18 10.09 323.67

IV I.(1+R)n (1tcg)+tcg.I 1.06 1.34 1.82 3.44 12.88 737.71

I After-tax rate of return 4.90 4.90 4.90 4.90 4.90 4.90

II After-tax rate of return 4.90 5.09 5.31 5.66 6.12 6.62

III After-tax rate of return 5.95 5.95 5.95 5.95 5.95 5.95

IV After-tax rate of return 5.95 6.06 6.18 6.37 6.60 6.83

Comparison:

Accumulation in Vehicle IV is similar to that for Vehicle II except thatincome from Vehicle IV is taxed at more favourable tcg.

Vehicle IV is superior to Vehicles II & III except for special cases: tcg= 0

andtcg= t.


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Slide 1-13

Savings Vehicle V(Intertemporally Constant Tax Rates)

SavingsVehicle


n=1 n=5 n=10 n=20 n=40 n=100

I I.[1+R(1t)]n 1.05 1.27 1.61 2.60 6.78 119.55

II I.(1+R)n (1t)+t.I 1.05 1.28 1.68 3.01 10.78 607.70

III I.[1+R(1tcg)]n 1.06 1.34 1.78 3.18 10.09 323.67

IV I.(1+R)n

(1tcg)+tcg.I 1.06 1.34 1.82 3.44 12.88 737.71V I.(1+R)n 1.07 1.40 1.97 3.87 14.97 867.72

I After-tax rate of return 4.90 4.90 4.90 4.90 4.90 4.90

II After-tax rate of return 4.90 5.09 5.31 5.66 6.12 6.62

III After-tax rate of return 5.95 5.95 5.95 5.95 5.95 5.95

IV After-tax rate of return 5.95 6.06 6.18 6.37 6.60 6.83

V After-tax rate of return 7.00 7.00 7.00 7.00 7.00 7.00

Comparison:

Accumulation in Vehicle V dominates that for Vehicle I through IV as long as the tcgis not 0%.

If tcg= 0, Vehicles III & IV generate exactly the same after-tax accumulations as in Vehicle V.


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Slide 1-14

Savings Vehicle V(Intertemporally Constant Tax Rates)

SavingsVehicle


n=1 n=5 n=10 n=20 n=40 n=100

V I.(1+R)n 1.07 1.40 1.97 3.87 14.97 867.72

VI [I.(1t)].(1+R)n (1t)

or I.(1+R)n

1.07 1.40 1.97 3.87 14.97 867.72

V After-tax rate of return 7.00 7.00 7.00 7.00 7.00 7.00

VI After-tax rate of return 7.00 7.00 7.00 7.00 7.00 7.00

In Vehicle VI, the investment is tax-deductible; and investment earnings are tax deferred.

Comparison:When tax rates are constant over time, Vehicles V and VI are equivalent. Hence,

Accumulation in Vehicle VI dominates that for Vehicle I through IV as long as the tcgis not 0%.

If tcg= 0, Vehicles III & IV generate exactly the same after-tax accumulations as in Vehicle VI.


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Slide 1-15

Dominance Relations and Empirical Anomalies

Considering the previous 6 types of Savings Vehicles:

It is found that there are several strict dominancerelations among the savings vehicles, i.e., investorswould always prefer to avoid some of the savings

vehicles. In the absence of frictions and restrictions, we would

never observe such tax-disfavoured vehicles asVehicle I (ordinary money market savings).

Yet, in the real world, money market savingscommand a larger share of the savings than most tax-favoured forms of savings.

The reasons stem largely from frictions and

restrictions.


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Slide 1-16

Changes in Tax Rates over Time

For pedagogical reasons, tax rates are assumed to be known and constantand here, this assumption is relaxed.

Even without frictions and restrictions, the dominance relations amongsavings vehicles disappear when we introduce intertemporal changes in taxrates.

In this setting, Vehicles V and VI are no longer equivalent.

In particular, when tax rates are rising, Vehicle VI (pensions) become lessattractive and when tax rates are falling over time, Vehicle VI (pensions)become more attractive.

Vehicle VI returns: [I.(1t0)].(1+R)n (1tn)

The subscript o indicates the tax rate in the period when the contribution ismade, assumed here to be the current period, and the subscript n indicatesthe tax rate in the future period n when withdrawals are made.

When tn>t0, Vehicle V is superior. Conversely, when tn


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Slide 1-17

Changes in Tax Rates over Time

Vehicle VI returns: [I.(1t0)].(1+R)n (1tn)

When t0=50% and tn=28%, then

Vehicle VI return = 1.44(1+R)n

Thus, Vehicle VI provides an after-tax accumulation of44%more thancomplete tax exemption.

When t0=31% and tn=40%, then

Vehicle VI return = .87(1+R)n

Thus,Vehicle VI provides an after-tax accumulation of13%less thancomplete tax exemption.


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Slide 1-18

End of the Chapter

Thank you.

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Session 03_Returns to Alternative Savings Vehicles