Before we go any further in our financial exploration, let’s talk a little bit about returns, and what kind of return should be important to us. Everything presented below is an approximation, a simplified view on how it really works just to carry my point across and make you think. If you want, I can present the actual formulas either in the comments or in another post. Please feel free to ask about it.
When we talk with clients about returns, or even when other people discuss returns on security, they usually talk about gross returns. And like gross annual salary or revenue of the company in its income statement, that’s all good and well, but what we really want to know is how much money we actually get in our hands or how much money the company has actually left in its accounts. We very much want to know the net amount after taxes.
Now, taxes are a whole different story, and I can talk for hours about them but they are different from country to country. Plus, each person’s tax situation is different. So, for the purposes of our example, let’s just assume that our investment produced a 6% annual return; that all that return consisted of interest income (as opposed to dividends or capital gains), 100% of which is taxed in Canada; and that our marginal tax rate is 50%. Well, if you live in Ontario, and you are in the highest tax bracket for both federal and provincial taxes, the maximum tax rate is 46.16% for 2018. However, to simplify the calculations, we will use 50%.
At this point, you may want to ask what’s a marginal tax rate. It’s a tax rate that you will pay on the next dollar of your income. Again, I will talk about different tax rates which are applicable in countries with progressive income tax system like Canada and US, and about taxation of different sources of income another time.
So, let’s get back to our example.
After tax income = (1 - tax rate) x (inclusion rate) x gross income
In our case, it will be:
After tax income = (1-0.5)x(1)x(6%)=3%.
That’s great but that’s not all. $100 in our hands now may or may not buy the same amount of goods and services as it did a year ago (and usually it doesn’t). This happens because of the inflation, meaning that over time the same amount of money can buy less. The actual inflation in the USA for 2018 is 1.9 %. In Canada, the numbers for 2018 vary from month to month but it’s also around 2%, so that’s what we are going to use in our calculation.
Net income after tax and inflation = Aftertax income - Inflation
In our case, it will be:
Net income after tax and inflation = 3%-2%=1%.
So, with a wave of our magic wand, our 6% somehow transformed into 1%. But this 1% is actually what’s important to us because this is how much money we will actually get after adjusting for taxes and inflation.
I’m originally from Ukraine, and quite often I have a similar conversation I had with a friend just a couple of weeks ago. Right now, the return you will earn on a Guaranteed Investment Certificate (GIC) in Canada, which is similar to Term deposits in the former Soviet Union, is 1.45% for one-year GIC in Canadian dollars (CAD). Meanwhile, in Ukraine, you can get about 14% for a one-year term deposit in national currency, Ukrainian Hryvna (UAH). Looking at these gross return rates, there is an obvious question, Is it better to invest money in UAH and earn 14% per year than in CAD and earn 1.45% per year? However, let’s remember the fundamental financial principle: the higher the risk, the higher the return. When you see 14% return vs. 1.45%, your first thought should be, “Wow! They want to pay me so much more in the risk premium for deposits in UAH. That means those deposits in UAH might be a lot riskier than deposits in CAD.”
Let’s use our approximation formulas to see what that 14 % will translate into net after taxes and inflation. For our example purposes, 14% is made of interest income only, and our marginal tax rate is still 50%. Please note, that we will calculate this from the point of view of a person living in a country with a progressive tax system. This calculation will be different for a Ukrainian tax resident because they do not file personal income taxes every year, and their tax system works differently.
After tax income = (1-0.5)x(1)x(14%)=7%.
However, the inflation in Ukraine is far from 2%. It’s approximately 10%, as per Ukrainian National Bank at the moment of writing this article.
Therefore, net income after tax and inflation = 7%-10%=-3%. Despite, such a beautiful gross return of 14%, we are not making any money. We are actually losing 3% per year and providing free financing to our bank.
Please think about this next time you have to make an investment decision.