Chapter

3
Returns to Alternative Savings Vehicle

Key Words / Outline

Slide 1-2

Distinguishing Alternative Savings Vehicles

Alternative savings vehicles are distinguished by their tax attributes: Tax-deductibility of the investment: whether deposits into the savings accounts give rise to an immediate tax deduction [tax-deductible or taxnondeductible] Frequency of taxation: the frequency with which investment earnings are taxed [tax-deduction at source, annual taxation, deferred taxation] Applicable tax rate: the rate at which the investment earnings are taxed [ordinary tax rate, special high tax rate, or concessionary rate]

Slide 1-3

Alternative Savings Vehicles

(Intertemporally Constant Tax Rates)
Savings Vehicle Taxdeductibility of the investment No No No No No Yes Frequency Applicable of taxation tax rate After-tax accumulation per after-tax Tk. I invested [F]

I II III IV V VI

Annually Deferred Annually Deferred Never Deferred

Ordinary Ordinary
Capital gains

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

Capital gains I.(1+R)n (1tcg)+tcg.I

Exempt Ordinary

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

or I.(1+R)n

Slide 1-4

Alternative Savings Vehicles

(Intertemporally Constant Tax Rates)
Savings Vehicle
TaxFrequency deductibility of taxation of investment

Applicable tax rate Ordinary Ordinary Capital gains Capital gains

Example in the USA Money Market Funds Single premium deferred annuity Mutual Fund Foreign corporations

I II III IV

No No No No

Annually Deferred Annually Deferred

V
VI

No
Yes

Never
Deferred

Exempt
Ordinary

Insurance Policy
Pension

Slide 1-5

Alternative Savings Vehicles

(Intertemporally Constant Tax Rates)
Savings Vehicle
TaxFrequency deductibility of taxation of investment

Applicable tax rate Ordinary Ordinary Capital gains Capital gains

Example in Bangladesh Money Market Funds Term Securities [Defense

Savings Certificate]

I II III IV

No No No No

Annually Deferred Annually Deferred

-------*** Corporate Investment in Shares

V
VI

No
Yes

Never
Deferred

Exempt
Ordinary

Insurance Policy
--------

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

Slide 1-6

Alternative Savings Vehicles

(Intertemporally Constant Tax Rates)
Savings Vehicle
Tax-deductibility of investment

Frequency of taxation Annually

Applicable tax rate

Capital gains

Example in Bangladesh ------- ***

III

No

***Reduced tax rate (5%-15%) for initial 5-6 years allowed to prescribed new industries
established between 1.7.2009 to 30.6.2012 (vide SRO 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 and Chittagong Divisions except for Rangamati, Bandarban and Khagrachari hill districts) and 5% for first 3 years; 10% for next 3 years (industries in other areas)].

Savings Vehicle

Tax-deductibility of investment

Frequency of taxation

Applicable tax rate

Example in Bangladesh

VI

Yes

Deferred

Ordinary

--------***

*** Employers contributions towards Approved Pension Fund are tax-deductible [para 5(2), Part A, 1st Sch 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.

Slide 1-7

Alternative Savings Vehicles

(Intertemporally Constant Tax Rates)
Savings After-tax accumulation per after-tax Tk. I Vehicle invested [F] (USA)
I = Tk. 1 n=1
R = 7%

t = 30% n=10 1.61 1.68 1.78 1.82 1.97 n=20 2.60 3.01 3.18 3.44 3.87

tcg = 15% n=40 6.78

10.78 10.09

n=5 1.27 1.28

n=100 119.55 607.70 323.67 737.71 867.72

I II III IV V

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

I.(1+R)n (1tcg)+tcg.I

1.05 1.05 1.06 1.06 1.07

1.34 1.34 1.40

12.88

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

14.97

VI

1.07

1.40

1.97

3.87

14.97

867.72

or I.(1+R)n

Slide 1-8

Alternative Savings Vehicles

(Intertemporally Constant Tax Rates)
Savings Vehicle (USA)
After-tax rate of return I = Tk. 1 n=1
R = 7%

t = 30% n=10 n=20

tcg = 15% n=40 n=100

n=5

I II III IV V VI

[F I]1/n 1 [F I]1/n 1 [F I]1/n 1 [F I]1/n 1 [F I]1/n 1 [F I]1/n 1

4.90 4.90 5.95 5.95 7.00 7.00

4.90 5.09 5.95 6.06 7.00 7.00

4.90 5.31 5.95 6.18 7.00 7.00

4.90 5.66 5.95 6.37 7.00 7.00

4.90 6.12 5.95 6.60 7.00 7.00

4.90 6.62 5.95 6.83 7.00 7.00

Slide 1-9

Savings Vehicles I and II

(Intertemporally Constant Tax Rates)
Savings After-tax accumulation per after-tax Tk. I Vehicle invested [F] (USA)
I = Tk. 1 n=1
R = 7%

t = 30% n=10 1.61 1.68 n=20 2.60 3.01

tcg = 15% n=40 6.78

10.78

n=5 1.27 1.28

n=100 119.55 607.70

I II

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

1.05 1.05

Comparison: For investment horizons of only one period (n=1), Vehicle I and Vehicle II are equivalent.
Except for n=1, the after-tax accumulation in Vehicle II always exceeds that in Vehicle I. The longer the holding period, the greater the difference in accumulation.

Slide 1-10

Savings Vehicles I and II

(Intertemporally Constant Tax Rates)
Savings Vehicle (USA)
After-tax rate of return I = Tk. 1 n=1

R = 7%
n=5

t = 30% n=10 n=20

tcg = 15% n=40 n=100

(r)

I II

[F I]1/n 1 [F I]1/n 1

4.90 4.90

4.90 5.09

4.90 5.31

4.90 5.66

4.90 6.12

4.90 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%.

Savings Vehicles II and III

(Intertemporally Constant Tax Rates)
Savings After-tax accumulation per after-tax Tk. I Vehicle invested [F] (USA)
I = Tk. 1 n=1
R = 7%

Slide 1-11

t = 30% n=10 1.68 1.78 n=20 3.01 3.18

tcg = 15% n=40

10.78 10.09

n=5 1.28

n=100 607.70 323.67

II III II III

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

After-tax rate of return (r) After-tax rate of return (r)

1.05 1.06 4.90 5.95

1.34 5.09 5.95

5.31 5.95

5.66 5.95

6.12 5.95

6.62 5.95

Comparison: Vehicle II may be more attractive than Vehicle III depending on n and tcg. For example, if tcg =0, Vehicle III always dominates Vehicle II, even for n=1 If 0<tcg<t, Vehicle III dominates Vehicle II for shorter n, but Vehicle II dominates for longer n.

Slide 1-12

Savings Vehicle IV
(Intertemporally Constant Tax Rates)
Savings Vehicle I II III IV After-tax accumulation I.[1+R(1t)]n I.(1+R)n (1t)+t.I I.[1+R(1tcg)]n I.(1+R)n (1tcg)+tcg.I I = Tk. 1 n=1 1.05 1.05 1.06 1.06 R = 7% n=5 1.27 1.28 1.34 1.34 t = 30% n=10 1.61 1.68 1.78 1.82 n=20 2.60 3.01 3.18 3.44 tcg = 15% n=40 6.78 10.78 10.09 12.88 n=100 119.55 607.70 323.67 737.71

I
II III IV

After-tax rate of return

After-tax rate of return After-tax rate of return After-tax rate of return

4.90
4.90 5.95 5.95

4.90
5.09 5.95 6.06

4.90
5.31 5.95 6.18

4.90
5.66 5.95 6.37

4.90
6.12 5.95 6.60

4.90
6.62 5.95 6.83

Comparison: Accumulation in Vehicle IV is similar to that for Vehicle II except that income from Vehicle IV is taxed at more favourable tcg. Vehicle IV is superior to Vehicles II & III except for special cases: tcg= 0 and tcg= t.

Savings Vehicle V
(Intertemporally Constant Tax Rates)
Savings Vehicle I After-tax accumulation I.[1+R(1t)]n I = Tk. 1 n=1 1.05 R = 7% n=5 1.27 t = 30% n=10 1.61 n=20 2.60 n=40 6.78

Slide 1-13

tcg = 15% n=100 119.55

II
III IV V I II III IV V

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

1.05
1.06 1.06 1.07 4.90 4.90 5.95 5.95 7.00

1.28
1.34 1.34 1.40 4.90 5.09 5.95 6.06 7.00

1.68
1.78 1.82 1.97 4.90 5.31 5.95 6.18 7.00

3.01
3.18 3.44 3.87 4.90 5.66 5.95 6.37 7.00

10.78
10.09 12.88 14.97 4.90 6.12 5.95 6.60 7.00

607.70
323.67 737.71 867.72 4.90 6.62 5.95 6.83 7.00

After-tax rate of return After-tax rate of return After-tax rate of return After-tax rate of return After-tax rate of return

Comparison: Accumulation in Vehicle V dominates that for Vehicle I through IV as long as the tcg is not 0%. If tcg = 0, Vehicles III & IV generate exactly the same after-tax accumulations as in Vehicle V.

Savings Vehicle V
(Intertemporally Constant Tax Rates)
Savings Vehicle After-tax accumulation I = Tk. 1 n=1 R = 7% n=5 t = 30% n=10 n=20 n=40 14.97 14.97

Slide 1-14

tcg = 15% n=100

V VI V VI

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

1.07 1.07

1.40 1.40

1.97 1.97

3.87 3.87

867.72 867.72

or I.(1+R)n
After-tax rate of return

7.00

7.00

7.00

7.00

7.00

7.00

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 tcg is not 0%. If tcg = 0, Vehicles III & IV generate exactly the same after-tax accumulations as in Vehicle VI.

Slide 1-15

Dominance Relations and Empirical Anomalies

Considering the previous 6 types of Savings Vehicles: It is found that there are several strict dominance relations among the savings vehicles, i.e., investors would always prefer to avoid some of the savings vehicles. In the absence of frictions and restrictions, we would never observe such tax-disfavoured vehicles as Vehicle I (ordinary money market savings). Yet, in the real world, money market savings command a larger share of the savings than most taxfavoured forms of savings. The reasons stem largely from frictions and restrictions.

Slide 1-16

Changes in Tax Rates over Time

For pedagogical reasons, tax rates are assumed to be known and constant and here, this assumption is relaxed. Even without frictions and restrictions, the dominance relations among savings vehicles disappear when we introduce intertemporal changes in tax rates. In this setting, Vehicles V and VI are no longer equivalent. In particular, when tax rates are rising, Vehicle VI (pensions) become less attractive 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 is made, assumed here to be the current period, and the subscript n indicates the tax rate in the future period n when withdrawals are made. When tn>t0, Vehicle V is superior. Conversely, when tn<t0, Vehicle VI is superior.

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 of 44% more than complete tax exemption.

When t0=31% and tn=40%, then Vehicle VI return = .87(1+R)n

Thus, Vehicle VI provides an after-tax accumulation of 13% less than complete tax exemption.

Slide 1-18

End of the Chapter

Thank you.