The Higher Equity Risk Premium Created by Taxation

Taxation and inflation have some surprising investment effects, such as raising the equity risk premium. Taxation and inflation combine to create some surprising results, and examples probed in this article show that the results apply to both fixed-income and equity investments. Using reasonable assumptions as to tax rates and expected rates of inflation, the article works through examples to illustrate what happens in various cases. The result is the following surprising findings:Higher nominal interest rates can actually result in lower (and often negative) real after-tax yields.In a taxed portfolio, the equity risk premium relative to the taxable risk-free rate can be significantly greater than the original tax-free risk premium.This “tax enhancement” of the risk premium grows even larger with higher nominal interest rates (although this effect may be ameliorated when municipal bonds with a high yield ratio can be used as the risk-free rate).At first, these results seem to argue that more taxation is better, but note that, although the risk premium increases, the returns to both the equity and the fixed-income investments shift downward.What do these results imply for asset allocation? The allocation environment of a tax-free institution is typically quite different from that of a taxed individual: Institutions have longer time horizons and stronger standby resources; hence, they may have a considerably greater tolerance for risk. However, for situations in which the individual and institution have similar levels of risk tolerance, the greater risk premium in the taxed portfolio argues that it should be able to support a higher allocation to equities than the comparable tax-free framework.Although being taxed brings little joy, investors and investment managers should recognize that taxation can actually lead to a higher compensation for accepting long-term equity risk, and this incremental risk may provide some small modicum of comfort.