Just being confused that when it says tax drag, it means the tax drag percentage or the tax drag amount.
Anyone knows?
In my experience Tax Drag is how much money taxes dragged away from your investment and it is assessed through the following ratio :
calculated taxes / [Net gain w/o taxes] where net gain w/o taxes is the tax exempted Future value - initial investment.
It can be both ways but rather the amount is the more talking one.
In the sample question in the cfai, normally when they talk about percentage they use “What proportion of the investment was consumed by taxes”. However to calculate this you need to know the amount value.
The numerator in the formula form sunseeker is not right. The numerator is the difference between the return if no tazx was deductd and the after tax return.
Which is the taxes paid along the timelines. Sorry guys what else can be that is subtracted from your income if not taxes?
See below some examples ;
"For example, €100 invested at 6 percent per annum for ten years in an envi- ronment in which returns are taxed each year at a rate of 30 percent will accumulate to be €100[1 + 0.06(1 − 0.30)]10 = €150.90. Had returns not been taxed, this investment would have grown to €100[1 + 0.06(1 − 0.00)]10 = €179.08, a difference of €28.18. Notice that taxes reduce the potential gain on investment by (€179.08 − €150.90)/ (€179.08 − €100.00) = €28.18 /€79.08 = 35.6 percent, which is more than the ordinary income tax rate. This suggests that the tax drag on capital accumulation compounds over time when taxes are paid each year. (Tax drag refers to the negative effect of taxes on after-tax returns.) "
Taxes paid 28.18 during the period (at the numerator level)
"_For example, let’s assume that John owns 100 shares of Company XYZ stock. He bought the stock at $10 per share, for a total of $1,000. The stock takes off, and he sells his shares for $15 per share, for a total of $1,500. John has made a $500 profit, or a 50% gain.However, that’s not quite the whole story. John has to pay capital gains tax on that investment. Assume the capital gains tax is 15% of $500, or $75. That means his actual return is not 50% but: ($500 - $75)/1,000 = 42.5% The tax drag is 50% - 42.5% = 7.5%" = **Taxes paid 75_ in the numerator (75 /1000)**
If we are assessing how many taxes take away our income how can’t taxes paid be not in the numerator as they represent “the loss” out of the total gain? Hope it helps.
I am sorry but I have to agree with MVL. The tax paid is not equal to the amount of the tax drag (that’s why it has a different name), or said differently, the tax paid differs from “the return if no tax was deducted minus the after tax return” (the latter being the correct input in the numerator of the formula). In your example €28 is the tax drag. The tax paid should be around €23 if I am not mistaken.
That’s the whole point about tax drag: it consumes more of your investment return than what is actually paid as tax because of the compounding effect.
Actually if the government would use your €23 tax to invest in the same portfolio as you at the time he receives your money, he would get €28 out of it at the end of the period.
That’s a peculiarity I haven’t taken into account. Thanks both for pointing out!
You’re welcome!