Growth Investments and Capital Gains
While there are a lot of tax jurisdictions with different rules, and one should always look to their own jurisdiction to get a clear picture of how any investment decision will affect their tax picture, there are some common principles that tend to apply generally.
One of them is the tax treatment for capital gains, and the reasons go further than just wanting people to invest in the stock market more. Economies depend on capital investment, which just happens to include buying and holding stocks of public companies.
By giving preferential tax treatment to capital investments, this has the benefit of stimulating the economy more than just reducing taxation generally, or at least that’s the intention. While it’s the case that growth investments are more along for the ride here than anything, within the bigger goal of encouraging capital investment generally, it’s also the case that governments want people to own and hold stock as well, as stock market valuations being higher is seen as wealth building.
This is seen to be the case even though these investments are valued by way of mark to market, valuing all of it based upon the last trade, even though this isn’t entirely valid. A good way to understand this is to imagine everyone looking to sell their shares which would drive share prices into the ground.
So a lot of the theoretical value is based upon looking to keep demand for stocks up such that they maintain their prices and even see these prices rise, which can only happen if demand stays sufficient.
So, we may see ourselves paying half of the normal tax in many cases on the profits from our stock ownership, with longer term holdings being given the most preferential treatment. If we hold the stocks for a lesser period of time, we may only be entitled to a percentage of this tax reduction, and in some jurisdictions, if we trade them frequently enough, we may not get any tax advantage.
Given that the growth segment of our portfolio tend to provide the highest returns historically, they tend to have two of our three key elements in their favor, the return part and the tax efficiency part. In terms of risk though, they are more volatile than other types of financial investments, and this consideration alone may have people well advised to reduce or eliminate this type of investment from their portfolio at certain points in time, depending on the circumstances..
Taxation and Income from Dividends
In between the tax efficiency of capital gains and the normal treatment of interest income is the way that dividend income is treated. With dividend income, this is not linked so directly to the goal of promoting capital investment, which encompasses pretty much all business activities, and promoting that is a central goal of governments to be sure.
Dividends on the other hand are strictly related to stock ownership, so what we get here with rules surrounding the taxation of dividends is how much that governments want to promote longer term stock ownership by itself, disconnected from the higher objective of stimulating capital investment in general.
Unlike normal capital investment, stock ownership generally does not have the same stimulating effect as other types, due to the fact that stocks are merely traded between people. If a company issues a certain amount of shares, it sells them to the public, and that initial offering is where the money that the business gets to grow themselves comes from, unless they issue more stock later.
After stock is issued, this stock can change hands but does not add any net growth to the businesses, at least directly anyway. Still though, governments want to reward people for holding stocks to look to ensure that the demand for them is kept at higher rather than lower levels, as this is considered healthy for a country’s economy, and certainly does effect it in a number of other ways.
So, there are various formulas that are used in determining the tax treatment of dividends, where the emphasis is usually on dividends paid by domestic companies. This is done to promote investment in these domestic companies versus foreign ones.
There’s also the view that dividend income itself is after tax income, as the companies themselves who issue the dividends have already paid tax on it. It could be argued that subjecting dividend income to income tax at all involves double taxation, and the compromise is to tax this income at a somewhat reduced rate anyway, provided that the dividends qualify for the tax reduction, which usually means that the company is located in the country that the investor lives.
Taxation and Interest Income
Interest income does not receive any special tax treatment, and therefore is the easiest asset class to manage and understand. Interest income includes interest earned with deposit products as well as interest earned with debt instruments like bonds.
While things like bonds and other interest bearing instruments certainly do have a real effect upon the economy, this effect is not seen as worthy of any tax stimulus. Governments couldn’t function without issuing debt though, companies rely heavily on issuing debt, and the banking system also relies primarily on interest bearing liabilities, as this forms the source of the money that they are able to lend.
Governments also complain that people don’t save enough, but at the same time do not bother to offer people any reason to do so aside from what the market offers. Whether or not this should be the case is a matter of debate.
When we look at the big picture here, the common theme is that tax breaks are offered as an incentive for risk taking, with capital expenditures having the highest level of risk and the highest tax breaks, with the lesser treatment of dividends involving lesser risk but more so than interest income, which has the lowest risk among these categories but has no special treatment.
The effect of this is that as people get closer to needing to cash in their savings, they usually will look to reduce their risk and therefore gravitate more and more toward assets that pay out interest income, such as bonds, debt backed securities, and deposit accounts.
If public policy is to reward risk taking by way of tax breaks, we may wonder about the suitability of this, given that these tax laws may provide people an incentive to make the wrong decisions, for instance to hang on to their stock market investments longer than they should, and expose themselves to an excessive amount of risk in their later years.
One of the main principles of long term investing is to reduce risk over time, not maintain it. However, as long as we are aware of this, we can avoid falling into this trap and having to liquidate a lot of our savings in the midst of a bear market, which is the main threat here.
It is often the case that these riskier investments are appropriate though, especially during the earlier years of one’s investment plan, and provided that these risks make sense for us, we can certainly benefit from their greater tax efficiency.
After retirement, when our income tends to be reduced, we may be in a better position to bear the full taxation rates of our more conservative investments, due to our often being in a lower tax bracket.
It may also be appropriate in some cases to continue to hold positions in the stock market even in our later years, to some degree anyway, depending on the balance of risk and return that is appropriate, and tax implications do play a role in these decisions as well.
So each type does have its place, and the way that they are taxed certainly does matter, but it’s important to realize that there are other factors that often are even more fundamental to these decisions, especially our capacity to bear the risks involved.