Example 3.4

The Net Return for the year is 3%. Tax is 20%, inflation is 2%. To calculate a real after-tax return, why do we subtract tax first and then account for inflation and not account for inflation first and deduct tax after?

Because taxes are assessed based on nominal returns. Assume the following: you have 3% inflation, a 10% return, and a 20% tax rate. You invest $100 for one year. What are you taxed on? The answer is the $10 interest you’ve earned. So, you made 8% after tax. Your REAL return would be 1.08/1.03-1 = 4.85%.

However, when you get to Level III, you’ll have to consider whether the account in which the investment occurs is taxable or not.

Until then, what the prof says goes.

Ok thanks.