Can someone explain to me in plain English why tax drag as a % decreases as return increases? I see the calculations but I find that I can’t explain why this happens.
Actually I think I got it. Is it because the tax effect (numerator) increases by a smaller % than the return (denominator) as the rate of return goes up? This happens bc the numerator includes taxes paid on principal also where as the denominator doesn’t?
Ahh I don’t know that doesn’t seem to make sense either. Can someone please help!? Thanks!
i hope this helps. the numerator which represents the difference between pretax value of investment and aftertax value of investment increases faster than the denominator which is the pretax profit. a longer time horizon combined with a higher return which are taxed have an adverse affect on growth. think of what would happen if you had a tax deferred investment where you were able to invest all gains on a pretax basis and you combined that with a high return plus a long time horizon.
sorry i missed your question. i think what happens is the effect of compounding combined with a high returns outweight/dampen the adverse effect of the wealth tax the longer the time horizon(all else equal). pretax profit increase at a slower rate than post tax profit. this is the numerator. the numerator increases at a slower rate than pretax profit (the denominator) as you increase the return which results in a decreasing tax drag.