Taxes – modviz

How to Calculate the Tax-Drag of Wealth Based Taxation

In the United States, there has been talk of implementing a wealth tax in order to generate revenue off of wealthier individuals. While the politics of a wealth tax are beyond the scope of this post, we can still examine the effects of wealth based taxation on a quantitative basis.

The future value interest factor formula that accounts for an annual tax on wealth is as follows:

FVIF of wealth based taxation formula

Where:

Assume that an individuals portfolio which comprises their entire net worth will grow at a required rate of 7% for 10 years and the tax rate on wealth is 1% annually, plugging those values into the formula will yield the following:

wheres; r = 0.07, wealth tax = 1%, n = 10

An individual with an initial net worth of $1,000,000 would be worth $1,779,100 in ten years.

On the surface, a 1% tax on wealth doesn’t seem like much when this individual’s portfolio is now worth $1.7mm dollars; however, let’s quantify the tax-drag that wealth based taxation has on net worth.

Recall that the formula used to calculate tax-drag is as follows:

where:

In order to calculate the tax-drag we need to compute the value of the portfolio without taxes as follows:

where; r = 0.07, n = 10, PV = $1,000,000

We can now plug the ending values of the tax-free and taxable accounts into the tax-drag formula:

The tax-drag in this particular scenario is 19.44%. In other words, a 1% tax on wealth every ten years eroded 19.44% of the appreciation relative to the tax-free account.

Constructing a tax-drag table that quantifies the effect wealth based taxation has over time will illustrate how destructive wealth taxes are even if wealth taxes are in the low single digits per annum.

First let’s construct the future value table for the tax-free account:

	Rate
	2%	3%	4%	5%	6%	7%
Year	($ 000s)
1	$ 1,020.00	$ 1,030.00	$ 1,040.00	$ 1,050.00	$ 1,060.00	$ 1,070.00
2	$ 1,040.40	$ 1,060.90	$ 1,081.60	$ 1,102.50	$ 1,123.60	$ 1,144.90
3	$ 1,061.21	$ 1,092.73	$ 1,124.86	$ 1,157.63	$ 1,191.02	$ 1,225.04
4	$ 1,082.43	$ 1,125.51	$ 1,169.86	$ 1,215.51	$ 1,262.48	$ 1,310.80
5	$ 1,104.08	$ 1,159.27	$ 1,216.65	$ 1,276.28	$ 1,338.23	$ 1,402.55
6	$ 1,126.16	$ 1,194.05	$ 1,265.32	$ 1,340.10	$ 1,418.52	$ 1,500.73
7	$ 1,148.69	$ 1,229.87	$ 1,315.93	$ 1,407.10	$ 1,503.63	$ 1,605.78
8	$ 1,171.66	$ 1,266.77	$ 1,368.57	$ 1,477.46	$ 1,593.85	$ 1,718.19
9	$ 1,195.09	$ 1,304.77	$ 1,423.31	$ 1,551.33	$ 1,689.48	$ 1,838.46
10	$ 1,218.99	$ 1,343.92	$ 1,480.24	$ 1,628.89	$ 1,790.85	$ 1,967.15

future value of tax-free account table

We’ll do the same for the taxable account assuming an annual wealth tax of 1%:

	Rate
	2%	3%	4%	5%	6%	7%
Year	($ 000s)
1	$ 1,009.80	$ 1,019.70	$ 1,029.60	$ 1,039.50	$ 1,049.40	$ 1,059.30
2	$ 1,019.70	$ 1,039.79	$ 1,060.08	$ 1,080.56	$ 1,101.24	$ 1,122.12
3	$ 1,029.69	$ 1,060.27	$ 1,091.45	$ 1,123.24	$ 1,155.64	$ 1,188.66
4	$ 1,039.78	$ 1,081.16	$ 1,123.76	$ 1,167.61	$ 1,212.73	$ 1,259.15
5	$ 1,049.97	$ 1,102.46	$ 1,157.02	$ 1,213.73	$ 1,272.64	$ 1,333.81
6	$ 1,060.26	$ 1,124.18	$ 1,191.27	$ 1,261.67	$ 1,335.51	$ 1,412.91
7	$ 1,070.65	$ 1,146.32	$ 1,226.53	$ 1,311.51	$ 1,401.48	$ 1,496.69
8	$ 1,081.14	$ 1,168.91	$ 1,262.84	$ 1,363.31	$ 1,470.71	$ 1,585.45
9	$ 1,091.74	$ 1,191.93	$ 1,300.22	$ 1,417.17	$ 1,543.37	$ 1,679.46
10	$ 1,102.44	$ 1,215.41	$ 1,338.71	$ 1,473.14	$ 1,619.61	$ 1,779.06

future value of taxable account

Now we can calculate the tax-drag table using the two tables above:

	Rate
	2%	3%	4%	5%	6%	7%
Year
1	51.00%	34.33%	26.00%	21.00%	17.67%	15.29%
2	51.25%	34.67%	26.38%	21.40%	18.09%	15.72%
3	51.49%	35.00%	26.76%	21.81%	18.52%	16.17%
4	51.74%	35.34%	27.14%	22.22%	18.95%	16.62%
5	51.99%	35.67%	27.52%	22.64%	19.39%	17.08%
6	52.24%	36.01%	27.91%	23.06%	19.83%	17.54%
7	52.48%	36.35%	28.30%	23.48%	20.28%	18.01%
8	52.73%	36.69%	28.69%	23.91%	20.73%	18.48%
9	52.98%	37.02%	29.08%	24.33%	21.19%	18.96%
10	53.22%	37.36%	29.47%	24.77%	21.65%	19.45%

tax-drag table

Notice how the tax-drag is much higher if your net worth grows at a lower assumed rate of return. Higher rates can somewhat offset the tax-drag; however, a 2% rate of return over ten years has a tax-drag of over 53.22%, and that’s if the annual wealth tax is “only” 1%. Imagine having a tax-drag of 53.22% over ten years before adjusting for inflation. Can you say, “Capital flight”?

The Excel model used to calculate the tax-drag of annual wealth taxes can be found here.

How to Calculate the Tax-Drag on a Taxable Account

In order to calculate the tax-drag on a taxable account, you need to compare the net after-tax future value of a taxable account to the future value of a tax-free account. These values are then plugged into the following formula:

Where:

We can define the ending value of a tax-free account as follows:

ending value of a tax-free account formula

The formula above is essentially the future value formula with a different set of variables. Recall, that the future value of a taxable account adjusts the rate of return by a quantity that takes into account annual accrual based taxation:

ending value of a taxable account formula

Assume you made a $1,000 investment into a security that was projected to pay a 4% dividend for ten years, with an annual dividend tax of 30%. What is the tax-drag on the taxable account relative to the tax-free account?

In order to calculate the tax-drag we need to plug the variables into both future value formulas:

where; V-naught = $1,000, r = 0.04, n = 10

Plugging those same values to solve for the ending value of the taxable account yields the following:

where; V-naught = $1,000, r = 0.04, t = 30%, n = 10

Now that we have calculated the ending values for both the tax-free and taxable accounts, we can plug those values into the tax-drag formula:

Notice that the tax-drag of 33.7% is higher than the annual tax rate of 30%. The additional tax erosion above and beyond the 30% annual rate of taxation is due to paying 30% every year in the taxable account, relative to not paying any taxes in the tax-free account.

We can illustrate the longer term detrimental effects of tax-drag by constructing a tax-drag table. Using Excel, let’s compute a future value table for a tax-free account, assuming an annual tax rate of 30%:

	Rate
	2%	3%	4%	5%	6%	7%
Year
1	$ 1,020.00	$ 1,030.00	$ 1,040.00	$ 1,050.00	$ 1,060.00	$ 1,070.00
2	$ 1,040.40	$ 1,060.90	$ 1,081.60	$ 1,102.50	$ 1,123.60	$ 1,144.90
3	$ 1,061.21	$ 1,092.73	$ 1,124.86	$ 1,157.63	$ 1,191.02	$ 1,225.04
4	$ 1,082.43	$ 1,125.51	$ 1,169.86	$ 1,215.51	$ 1,262.48	$ 1,310.80
5	$ 1,104.08	$ 1,159.27	$ 1,216.65	$ 1,276.28	$ 1,338.23	$ 1,402.55
6	$ 1,126.16	$ 1,194.05	$ 1,265.32	$ 1,340.10	$ 1,418.52	$ 1,500.73
7	$ 1,148.69	$ 1,229.87	$ 1,315.93	$ 1,407.10	$ 1,503.63	$ 1,605.78
8	$ 1,171.66	$ 1,266.77	$ 1,368.57	$ 1,477.46	$ 1,593.85	$ 1,718.19
9	$ 1,195.09	$ 1,304.77	$ 1,423.31	$ 1,551.33	$ 1,689.48	$ 1,838.46
10	$ 1,218.99	$ 1,343.92	$ 1,480.24	$ 1,628.89	$ 1,790.85	$ 1,967.15

future value of a tax-free account table

Let’s do the same for a taxable account:

	Rate
	2%	3%	4%	5%	6%	7%
Year
1	$ 1,014.00	$ 1,021.00	$ 1,028.00	$ 1,035.00	$ 1,042.00	$ 1,049.00
2	$ 1,028.20	$ 1,042.44	$ 1,056.78	$ 1,071.23	$ 1,085.76	$ 1,100.40
3	$ 1,042.59	$ 1,064.33	$ 1,086.37	$ 1,108.72	$ 1,131.37	$ 1,154.32
4	$ 1,057.19	$ 1,086.68	$ 1,116.79	$ 1,147.52	$ 1,178.88	$ 1,210.88
5	$ 1,071.99	$ 1,109.50	$ 1,148.06	$ 1,187.69	$ 1,228.40	$ 1,270.22
6	$ 1,087.00	$ 1,132.80	$ 1,180.21	$ 1,229.26	$ 1,279.99	$ 1,332.46
7	$ 1,102.21	$ 1,156.59	$ 1,213.25	$ 1,272.28	$ 1,333.75	$ 1,397.75
8	$ 1,117.64	$ 1,180.88	$ 1,247.23	$ 1,316.81	$ 1,389.77	$ 1,466.24
9	$ 1,133.29	$ 1,205.68	$ 1,282.15	$ 1,362.90	$ 1,448.14	$ 1,538.08
10	$ 1,149.16	$ 1,231.00	$ 1,318.05	$ 1,410.60	$ 1,508.96	$ 1,613.45

future value of a taxable account table

With these two tables, we can now compute a tax-drag table using the values above:

	Rate
	2%	3%	4%	5%	6%	7%
Year
1	30.00%	30.00%	30.00%	30.00%	30.00%	30.00%
2	30.21%	30.31%	30.41%	30.51%	30.61%	30.71%
3	30.42%	30.62%	30.83%	31.03%	31.23%	31.43%
4	30.63%	30.93%	31.24%	31.55%	31.85%	32.15%
5	30.83%	31.25%	31.66%	32.07%	32.47%	32.87%
6	31.04%	31.56%	32.08%	32.59%	33.10%	33.61%
7	31.26%	31.88%	32.50%	33.12%	33.73%	34.34%
8	31.47%	32.20%	32.92%	33.65%	34.37%	35.08%
9	31.68%	32.51%	33.35%	34.18%	35.00%	35.82%
10	31.89%	32.83%	33.77%	34.71%	35.64%	36.57%

30% tax-drag table

As you can see, the importance of sheltering gains from taxation (in a legal manner of course) becomes extremely important the longer the time frame, the higher the tax rate, and the higher the expected level of return. Based on the table above, the tax-drag on an investment with a 7% rate of return over 10 years is 36.57%, which is much higher than 30%.

Understanding the impact of tax-drag illustrates the importance of having a tax-diversification strategy in addition to an asset diversification strategy. For instance, hold longer term capital appreciating securities which pay no dividends or interest in a taxable account, while investing in interest bearing and dividend paying securities inside of tax-sheltered accounts such as Traditional IRAs and Roth IRAs or employer sponsored retirement plans.

Generally speaking, if taxes are paid on an annual basis the tax-drag will be greater than the tax rate. Conversely, if taxes are deferred until the end of the period the tax-drag will be equal to the tax rate.

A copy of the Excel model used to construct the tax-drag table can be found here.

How to Calculate Accrual Based Taxes on Interest and Dividends

Calculating the future value of an account that taxes interest and dividends on an annual basis requires a basic understanding of future value interest factors (FVIFs).

The formula utilized to calculate the FVIF which takes into account this method of taxation is as follows:

FVIF accrual based dividends formula

The annual taxation on dividends is reflected in the formula above by adjusting the rate of return by the quantity (1 – tax on dividends). The formula for accrual based taxes on interest is identical:

FVIF accrual based interest taxes formula

The only difference between the two formulas is the use of subscript “d” versus subscript “i”.

Let’s assume that an investment paid an annualized rate of interest of 4% for ten years, and the annual tax on interest was 15%. Plugging those values into the formula above would yield the following:

where; r = 0.04, t-interest = 15%, n = 10

If your initial investment was $1,000, you could calculate the future value in the tenth year by multiplying $1,000 by the FVIF of 1.3970:

future value

Using Excel we can construct a FVIF table that takes into account different rates of taxation on interest or dividends, the FVIF table below is constructed with a discount rate of 4%:

	t-interest
year	10%	15%	20%	25%	30%
1	1.03600	1.03400	1.03200	1.03000	1.02800
2	1.07330	1.06916	1.06502	1.06090	1.05678
3	1.11193	1.10551	1.09910	1.09273	1.08637
4	1.15196	1.14309	1.13428	1.12551	1.11679
5	1.19344	1.18196	1.17057	1.15927	1.14806
6	1.23640	1.22215	1.20803	1.19405	1.18021
7	1.28091	1.26370	1.24669	1.22987	1.21325
8	1.32702	1.30667	1.28658	1.26677	1.24723
9	1.37479	1.35109	1.32775	1.30477	1.28215
10	1.42429	1.39703	1.37024	1.34392	1.31805

FVIF accrual based taxes on interest table, where; r = 0.04

Obviously, the higher the rate of taxation the more it will reduce the FVIF.

The Excel model for FVIFs based on annual accrual taxation can be found here.

How to Calculate the Future Value of a Tax-Deferred Account

Recall, that the formula utilized to calculate the future value of a lump sum is as follows:

future value formula

Where:
FV = Future Value
PV = Present Value
r = rate
n = periods

Calculating the future value of a tax-deferred account incorporates the tax paid on the money when it is withdrawn during the final period. We can account for the taxes paid by adjusting the present value after it has been compounded by the specified rate and number of periods:

future value of a tax-deferred account

The addition of the quantity (1 – t) adjusts the future value in the final period by the tax that is owed.

Assume you have a present value of $1,000, the will grow at a rate of 7% for ten years, with an assumed tax rate of 30%. Plugging those values into the formula will yield the following:

where; PV = $1,000, rate = 0.07, n = 10, t = 30%

Using Excel, we can model what happens during each of the ten periods:

Year	PV	rate	FV	Tax (30%)
1	$ 1,000.00	7%	$ 1,070.00
2	$ 1,070.00	7%	$ 1,144.90
3	$ 1,144.90	7%	$ 1,225.04
4	$ 1,225.04	7%	$ 1,310.80
5	$ 1,310.80	7%	$ 1,402.55
6	$ 1,402.55	7%	$ 1,500.73
7	$ 1,500.73	7%	$ 1,605.78
8	$ 1,605.78	7%	$ 1,718.19
9	$ 1,718.19	7%	$ 1,838.46
10	$ 1,838.46	7%	$ 1,967.15
Tax				$ 590.15
Net ATFV			$ 1,377.01

future value of a tax-deferred account table

Notice how the tax is paid during the final period. In the United States, this is how the future value of a Traditional IRA would be calculated. We can represent the table above visually with the following chart:

future value of a tax-deferred account chart

Using an HP12C calculator, we can calculate the future value of a tax-deferred account with the following keystrokes:

[1000][PV]
[7][i]
[10][n][FV]
[.][7][*]

The formula can be rearranged as follows to find the present value of a tax-deferred account:

The present value of a tax-deferred account formula is usually only seen on tests which require you to calculate the present value of a tax-deferred account based on an initial investment an investor made in the past, given some current value in the future.

A copy of the Excel model can be found here.