Tax and your real return

Chapter 11 of the fixed income subject ran this arithmetic for bonds. This chapter generalises it, because it applies to everything and almost nobody computes it.

The two subtractions, in order

Order matters, and getting it wrong flatters the result.

Tax is charged on nominal income. Inflation is then applied to what is left.

after-tax return = nominal return × (1 − marginal rate)
real after-tax   = after-tax return − inflation

A 7.5% instrument, a 30% marginal rate, 5% inflation:

7.5% × 0.70 = 5.25%
5.25% − 5%  = 0.25%

A quarter of a percentage point. The headline said 7.5%.

Why tax makes inflation worse than it looks

The part that gets missed, and it is the point of the chapter.

With 7.5% nominal and 5% inflation, only 2.5 points of that return is real — the rest merely kept pace with prices. But the tax is charged on all 7.5.

At a 30% marginal rate the tax takes 2.25 points out of a 2.5 point real return. That is an effective rate of about 90% on the only part that mattered.

And it gets worse as inflation rises, even if nominal yields rise to match — because the tax is levied on the larger nominal number while the real return is unchanged.

So inflation and taxation interact against the saver, and the interaction is invisible in every quoted yield. The headline rate is nominal and pre-tax; the thing you can actually spend is neither.

Why this falls hardest on interest

Chapter 3's classification, with its consequence.

Interest is taxed as it arises, at slab rates, under the residuary head, with no reward for waiting. Every year's return is reduced before the next year compounds on it.

A capital gain is taxed on realisation, under its own regime, with a holding-period distinction. Chapter 4: the whole amount compounds untaxed until you sell, and you choose when.

Over one year these differ by the rate. Over thirty they differ by far more, because one has been compounding on a reduced base annually and the other has not.

Which is why the asymmetry stated in chapter 3 is a structural fact rather than a quirk: fixed income is taxed less favourably, consistently.

What this does not mean

Two conclusions people reach and should not.

It does not mean avoid fixed income. Chapter 11 of the fixed income subject and chapter 1 of the risk subject both insist: money needed on a date belongs in something matched to that date, and paying tax on a certain return beats taking market risk with money you need in two years. Tax changes the size of the advantage, not which asset suits which job.

It does not mean chase tax efficiency. Chapter 7: the tax tail wagging the investment dog is the expensive habit. A tax-efficient holding of the wrong asset for your horizon is worse than a tax-inefficient holding of the right one.

What it does mean

Three things.

Quote yourself real after-tax numbers. Pre-tax yields across instruments with different treatments compare nothing — chapter 3's rule. A 7.5% deposit and a 7.5% expected equity return are not comparable before tax and are differently incomparable after.

Long holding periods are worth more than they look. Deferral is a return, for chapter 4's reason. The decision to hold rather than churn has a tax value independent of the investment merits.

Asset location is free. Chapter 7. Interest-bearing assets suffer most in a taxable account, so putting them where interest is treated best raises your after-tax return without changing your allocation or your risk.

The number to compute once

For each significant holding:

real after-tax = (nominal return × (1 − your marginal rate)) − inflation

Then ask what fraction of the real return the tax took. For a slab-rate instrument in a moderate-inflation year, that fraction is routinely well above half, and often most of it.

Most people have never computed this for anything they own. It is one line per holding and it changes what you think the dull instruments are doing for you.

The point

Tax is charged on nominal income, so the effective rate on your real return is far above your marginal rate — and it rises with inflation even when yields rise to match. The effect is worst for interest, taxed annually at slab rates, and mildest for gains that compound untaxed until realised. Compute the real after-tax figure once per holding.