Tax Aware

## Inflation and Tax Efficiency

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Inflation and Tax Efficiency

Inflation hurts investors’ bottom lines even more than you might realize.

Inflation and taxes are linked in at least two ways. The first is straightforward, and often called “bracket creep”. For more, see, e.g., Beer et al. 2023.   The idea is that tax bracket cutoffs adjust upward with inflation, but at a lag. So, if your income this year moved up one-for-one with inflation, in real terms, you’re no better off than you were last year; but from a tax perspective, that nominal increase gets taxed at your highest marginal rate. The result: your overall effective tax rate has gone up.

The second way is subtle, but for an investment portfolio can matter much more. To illustrate with an example, suppose an investor buys a stock for \$100, and sells it a year later for \$110. That \$10 gain is taxed at a long-term rate, which we’ll assume here to be 23.8%, resulting in a \$2.38 tax bill.

But what if inflation was 4% over that year? In real terms, the investor made only \$6, but the tax bill is still based on the \$10 nominal gain. The result: the investor’s effective tax rate goes up. In this case, the investor will pay a 39.7% effective tax rate in real terms (\$2.38 on a \$6 real gain).

In the table below, we show the effective tax rate for different levels of inflation and different portfolio returns (assuming a one-year investment horizon). Regardless of how strong your portfolio’s returns are, higher inflation leads to a higher effective tax rate.

A Nominal Tax Rate of 23.8% turns into an Effective Tax Rate of:

*N/A here is technically an infinite tax rate, as the investor would pay taxes on a zero percent real return.
See Beer, et al (2023) for more.

What’s an investor to do? There are three options: 1) lower the inflation rate, 2) increase their portfolio’s expected return, and 3) improve their portfolio’s tax efficiency. Option 1 is nice work if you can get it.  Option 2 is a good idea, but presumably it’s also something investors have already spent a lot of time maximizing. To us, the clear source of low-hanging fruit is Option 3.

The chart below illustrates the potential benefit of becoming more tax efficient, for different levels of inflation. Each of the bars is the tax bill for an investor with a \$10 million portfolio that generates a 5% real return. The first set of bars are for a portfolio whose returns are highly taxed (e.g., short-term capital gains and ordinary income rates); the middle bars are for returns taxed at long-term rates; and the last bars are for a tax-efficient portfolio (i.e., where taxes are deferred, and where we assume a 10% tax as the present value of a future “true-up”).

Even when inflation is at 0%, tax efficiency is a good idea (first trio of blue bars). But the insight here is that tax efficiency becomes even more valuable when inflation is a feature of the macroeconomic environment, as it has become these days. The green triangles illustrate the case of the fully tax efficient versus the high tax portfolio. Even without inflation, tax efficiency can add a lot of value; and at higher levels, these differences become (we think) a very meaningful source of “alpha”.

Inflation can be a drag on wealth. The good news for investors, though, is today they have practical solutions for making their overall portfolios more tax efficient.

Inflation Makes Tax Efficiency Even More Important

\$10M portfolios, each with a 5% real return

Source: AQR. See Beer et al (2023) for more on this topic. Results above are based on tax rates of 40.8%, 23.8% and 10.0%, and assume a \$10M portfolio with a 5% real return. Effective tax is calculated as: tax rate*(1+(inflation rate / ([real return]*[1+inflation rate]))).

This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor. The reader should conduct his or her own analysis and consult with professional advisors prior to making any investment decision.

This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.

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