Sunday 11 November 2007

Taxation and Wealth Creation

Although taxation should never be the sole deciding factor when making investment decisions (after all it is much better to pay tax on a profitable investment that it is to end up losing money investing in a "tax scheme") it is important to make your investment portfolio as "tax efficient" as possible. The first step is to be aware of just how big an impact taxation can have on your wealth creation plans. Tax rates are suject to legislative risk (that is, they can change unexpectedly when new tax laws come into effect). This can be seen clearly from the change in the taxation situation in Australia over the past 25 years:

In 1983 In 2008
Capital Gain Tax 0% Marginal Tax Rate*
Tax-free threshold $4,462 $6,000
Lowest Tax Rate 30.67% 15.00%
Highwest Tax Rate 60.00% 45.00%
GST Tax Rate 0% 10%**

One thing that becomes immediately apparent is that the tax system has shifted significantly from direct taxation (income tax) to a more widely-based system of indirect taxation (capital gains and goods and services being taxed).

So, over the long term one can't be sure what tax rates might apply. However, using current tax rates one can see the effect of different tax rates on the return on your investments:

Investment return 8% 10% 12%
After tax @ 15% 6.8% 8.5% 10.2%
less inflation 3% 3% 3%
net real rate of return 3.8% 5.5% 7.2%

Investment return 8% 10% 12%
After tax @ 45% 4.4% 5.5% 6.6%
less inflation 3% 3% 3%
net real rate of return 1.4% 2.5% 3.6%

The true impact becomes even more apparent over the longer term. Just look at the difference in final value of $10,000 invested at 12% with a marginal tax rate of 15% compared with 45%:

Tax Rate applied to returns 15% 45%
Value after 20 years $40,169 $20,286

This highlights why it is so important to make use of any tax-advantaged investment options, such as investing within a superannuation account.

* a 50% discount if assets disposed of more than 12 months after purchase.
** GST doesn't apply to 'essentials' like unprocessed food, water and financial transactions.

Copyright Enough Wealth 2007

1 comment:

traineeinvestor said...

This is one of the reasons why I like living in Hong Kong - moderate taxes on income and rents, almost no taxes on capital gains, no taxes on dividends or interest and no estate duty any more. Tax planning has almost no role in my investment decison making.

Of course, there is a down side with many goods and services (and the cost of living generallY being a lot higher than in many other countries.