where p~ is the cost of capital (pre-tax rate of return
on investment) defined as:
Just compare the current pre-tax rate of return
to the return an investor would otherwise seek.
Scottish and Southern Energy complained earlier this month that the 4.7 percent pre-tax rate of return
allowed by Ofgem on investments in local electricity networks was below the 5.1 percent permitted for water utilities.
Next, compare that scenario with rolling over the stock into an IRA, selling it tax-free inside the IRA, assuming a suitably higher pre-tax rate of return
, and paying taxes on the mandatory distributions starting at age 70 1/2.
All else equal, a bank that holds a large amount of tax-advantaged securities may have a relatively low pre-tax rate of return
but a relatively high after-tax rate of return.
This combination may result in distortions in the after-tax rate of return differentials (i.e., in after-tax rate of return differentials not corresponding to pre-tax rate of return
Gravelle (1994) characterizes a tax rule as neutral when an investment's after-tax rate of return equals the product of its pre-tax rate of return
and 1 - t, where t is the statutory tax rate.
The ETR is obtained as the difference between the pre-tax rate of return
and the post-tax rate of returns (tax-wedge concept) and expressed as a percentage of the real pre-tax return on the investment.
It confers a post-tax rate of return on saving equal to the pre-tax rate of return
. An individual earning 100 can choose either to spend now, paying 25 of tax and consuming goods worth 75, or to save now and consume goods worth 120.79 in five years 1120.79 is simply 75 multiplied by (1.1).
This article assumes that stocks earn a 10.5% annual return, the pre-tax rate of return
earned on stocks from 1926-1997.(5) While this is a historically higher annual return than on bonds, stocks have greater volatility.