3

Returns to Alternative
Savings Vehicle

Key Words / Outline

Chapter

Distinguishing Alternative Savings

Slide 1Vehicles
2

Alternative savings vehicles are distinguished by

their tax attributes:
Tax-deductibility of the investment: whether deposits
into the savings accounts give rise to an immediate
tax deduction [tax-deductible or tax-nondeductible]
Frequency of taxation: the frequency with which
investment earnings are taxed [tax-deduction at
source, annual taxation, deferred taxation]
Applicable tax rate: the rate at which the investment
earnings are taxed [ordinary tax rate, special high
tax rate, or concessionary rate]

Alternative Savings Vehicles

(Intertemporally Constant Tax Rates)
Frequency Applicable
of taxation
tax rate

Slide 13

Savings
Vehicle

Taxdeductibility
of the
investment

After-tax accumulation
per after-tax Tk. I
invested [F]

No

Annually

Ordinary

I.[1+R(1t)]n

II

No

Deferred

Ordinary

I.(1+R)n (1t)+t.I

III

No

Annually

Capital gains

IV

No

Deferred

Capital gains I.(1+R)n (1tcg)+tcg.I

No

Never

Exempt

I.(1+R)n

VI

Yes

Deferred

Ordinary

[I.(1t)].(1+R)n (1t)

I.[1+R(1tcg)]n

or I.(1+R)n

Alternative Savings Vehicles

(Intertemporally Constant Tax Rates)
Savings
Vehicle

TaxFrequency
deductibility of taxation
of investment

Slide 14

Applicable
tax rate

Example in
the USA

No

Annually

Ordinary

Money Market Funds

II

No

Deferred

Ordinary

Single premium deferred

annuity

III

No

Annually

Capital
gains

Mutual Fund

IV

No

Deferred

Capital
gains

Foreign corporations

No

Never

Exempt

Insurance Policy

VI

Yes

Deferred

Ordinary

Pension

Alternative Savings Vehicles

(Intertemporally Constant Tax Rates)
Savings
Vehicle

TaxFrequency
deductibility of taxation
of investment

Slide 15

Applicable
tax rate

Example in
Bangladesh

No

Annually

Ordinary

Money Market Funds

II

No

Deferred

Ordinary

Term Securities [Defense

III

No

Annually

Capital
gains

-------***

IV

No

Deferred

Capital
gains

Corporate Investment in
Shares

No

Never

Exempt

Insurance Policy

VI

Yes

Deferred

Ordinary

--------

Savings Certificate]

***Income of the mutual fund of the person issuing such mutual fund is exempted u/p 30,
Part A, 6th Sch.

Slide 16

Alternative Savings Vehicles

(Intertemporally Constant Tax Rates)
Savings
Vehicle

Tax-deductibility
of investment

Frequency of
taxation

Applicable
tax rate

Example in
Bangladesh

III

No

Annually

Capital gains

------- ***

***Reduced tax rate (5%-15%) for initial 5-6 years allowed to prescribed new industries
established between 1.7.2009 to 30.6.2012 (vide SRO No. 172-Ain/Aykar/2009, dt. 1.7.2009).
[Tax Rates: 5% for first 2 years; 10% for next 2 years; 15% for next 1 year (industries in Dhaka and
Chittagong Divisions except for Rangamati, Bandarban and Khagrachari hill districts) and 5% for first 3
years; 10% for next 3 years (industries in other areas)].

Savings
Vehicle

Tax-deductibility
of investment

Frequency of
taxation

Applicable
tax rate

Example in
Bangladesh

VI

Yes

Deferred

Ordinary

--------***

*** Employers contributions towards Approved Pension Fund are tax-deductible [para 5(2), Part A, 1 st
Sch of ITO]
Income of the Fund (interest, dividend or capital gains) are exempted from tax [u/p 5(1)]
Pension received by employee is exempted u/p 8, Part A, 6 th Sch.

Slide 17

Alternative Savings Vehicles

(Intertemporally Constant Tax Rates)
Savings After-tax accumulation
per after-tax Tk. I
Vehicle
invested [F]
(USA)

I
II
III
IV
V
VI

I = Tk. 1

R = 7%

n=1

n=5

n=10

n=20

n=40

n=100

I.[1+R(1t)]n

1.05

1.27

1.61

2.60

6.78

119.55

I.(1+R)n (1t)+t.I

1.05

1.28

1.68

3.01

10.78

607.70

I.[1+R(1tcg)]n

1.06

1.34

1.78

3.18

10.09

323.67

I.(1+R)n (1tcg)+tcg.I

1.06

1.34

1.82

3.44

12.88

737.71

I.(1+R)n

1.07

1.40

1.97

3.87

14.97

867.72

[I.(1t)].(1+R)n (1t)

1.07

1.40

1.97

3.87

14.97

867.72

or I.(1+R)n

t = 30%

tcg = 15%

Alternative Savings Vehicles

(Intertemporally Constant Tax Rates)
Savings
Vehicle
(USA)

I
II
III
IV
V
VI

After-tax rate of
return

t = 30%

Slide 18

I = Tk. 1

R = 7%

n=1

n=5

n=10

n=20

n=40

n=100

[F I]1/n 1

4.90

4.90

4.90

4.90

4.90

4.90

[F I]1/n 1

4.90

5.09

5.31

5.66

6.12

6.62

[F I]1/n 1

5.95

5.95

5.95

5.95

5.95

5.95

[F I]1/n 1

5.95

6.06

6.18

6.37

6.60

6.83

[F I]1/n 1

7.00

7.00

7.00

7.00

7.00

7.00

[F I]1/n 1

7.00

7.00

7.00

7.00

7.00

7.00

tcg = 15%

Slide 19

Savings Vehicles I and II

(Intertemporally Constant Tax Rates)
Savings After-tax accumulation
per after-tax Tk. I
Vehicle
invested [F]
(USA)

I
II

I = Tk. 1

R = 7%

t = 30%

n=1

n=5

n=10

n=20

n=40

n=100

I.[1+R(1t)]n

1.05

1.27

1.61

2.60

6.78

119.55

I.(1+R)n (1t)+t.I

1.05

1.28

1.68

3.01

10.78

607.70

tcg = 15%

Comparison:
For investment horizons of only one period (n=1), Vehicle I and
Vehicle II are equivalent.
Except for n=1, the after-tax accumulation in Vehicle II always
exceeds that in Vehicle I.
The longer the holding period, the greater the difference in
accumulation.

Slide 110

Savings Vehicles I and II

(Intertemporally Constant Tax Rates)
Savings
Vehicle
(USA)

I
II

After-tax rate of
return

I = Tk. 1

R = 7%

n=1

n=5

n=10

n=20

n=40

n=100

[F I]1/n 1

4.90

4.90

4.90

4.90

4.90

4.90

[F I]1/n 1

4.90

5.09

5.31

5.66

6.12

6.62

(r)

t = 30%

tcg = 15%

Comparison:
All the after-tax annualized rates of return (r) are 4.9% in
Vehicle I.
But these rates increase in Vehicle II with the number of
holding periods.
In fact, in case of Vehicle II, as the number of periods becomes large,
the after-tax rate of return per period approaches the before tax rates
of return (R) of 7%.

Savings Vehicles II and III

(Intertemporally Constant Tax Rates)
Savings After-tax accumulation
per after-tax Tk. I
Vehicle
invested [F]
(USA)

t = 30%

Slide 111

I = Tk. 1

R = 7%

n=1

n=5

n=10

n=20

n=40

n=100

tcg = 15%

II
III
II

I.(1+R)n (1t)+t.I

1.05

1.28

1.68

3.01

10.78

607.70

I.[1+R(1tcg)]n

1.06

1.34

1.78

3.18

10.09

323.67

After-tax rate of
return (r)

4.90

5.09

5.31

5.66

6.12

6.62

III

After-tax rate of
return (r)

5.95

5.95

5.95

5.95

5.95

5.95

Comparison: Vehicle II may be more attractive than Vehicle III depending

on n and tcg. For example,
if tcg =0, Vehicle III always dominates Vehicle II, even for n=1
If 0<tcg<t, Vehicle III dominates Vehicle II for shorter n, but Vehicle II
dominates for longer n.

Slide 112

Savings Vehicle IV
(Intertemporally Constant Tax Rates)
Savings
Vehicle

After-tax accumulation

I = Tk. 1

R = 7%

t = 30%

tcg = 15%

n=1

n=5

n=10

n=20

n=40

n=100

I.[1+R(1t)]n

1.05

1.27

1.61

2.60

6.78

119.55

II

I.(1+R)n (1t)+t.I

1.05

1.28

1.68

3.01

10.78

607.70

III

I.[1+R(1tcg)]n

1.06

1.34

1.78

3.18

10.09

323.67

IV

I.(1+R)n (1tcg)+tcg.I

1.06

1.34

1.82

3.44

12.88

737.71

After-tax rate of return

4.90

4.90

4.90

4.90

4.90

4.90

II

After-tax rate of return

4.90

5.09

5.31

5.66

6.12

6.62

III

After-tax rate of return

5.95

5.95

5.95

5.95

5.95

5.95

IV

After-tax rate of return

5.95

6.06

6.18

6.37

6.60

6.83

Comparison:

Accumulation in Vehicle IV is similar to that for Vehicle II except that

income from Vehicle IV is taxed at more favourable tcg.
Vehicle IV is superior to Vehicles II & III except for special cases: tcg= 0
and tcg= t.

Slide 113

Savings Vehicle V
(Intertemporally Constant Tax Rates)
Savings
Vehicle

After-tax accumulation

I = Tk. 1

R = 7%

t = 30%

tcg = 15%

n=1

n=5

n=10

n=20

n=40

n=100

I.[1+R(1t)]n

1.05

1.27

1.61

2.60

6.78

119.55

II

I.(1+R)n (1t)+t.I

1.05

1.28

1.68

3.01

10.78

607.70

III

I.[1+R(1tcg)]n

1.06

1.34

1.78

3.18

10.09

323.67

IV

I.(1+R)n (1tcg)+tcg.I

1.06

1.34

1.82

3.44

12.88

737.71

I.(1+R)n

1.07

1.40

1.97

3.87

14.97

867.72

After-tax rate of return

4.90

4.90

4.90

4.90

4.90

4.90

II

After-tax rate of return

4.90

5.09

5.31

5.66

6.12

6.62

III

After-tax rate of return

5.95

5.95

5.95

5.95

5.95

5.95

IV

After-tax rate of return

5.95

6.06

6.18

6.37

6.60

6.83

After-tax rate of return

7.00

7.00

7.00

7.00

7.00

7.00

Comparison:
Accumulation in Vehicle V dominates that for Vehicle I through IV as long as the tcg is not 0%.
If tcg = 0, Vehicles III & IV generate exactly the same after-tax accumulations as in Vehicle V.

Slide 114

Savings Vehicle V
(Intertemporally Constant Tax Rates)
Savings
Vehicle

V
VI

After-tax accumulation

I = Tk. 1

R = 7%

t = 30%

tcg = 15%

n=1

n=5

n=10

n=20

n=40

n=100

I.(1+R)n

1.07

1.40

1.97

3.87

14.97

867.72

[I.(1t)].(1+R)n (1t)

1.07

1.40

1.97

3.87

14.97

867.72

After-tax rate of return

7.00

7.00

7.00

7.00

7.00

7.00

After-tax rate of return

7.00

7.00

7.00

7.00

7.00

7.00

or I.(1+R)n

V
VI

In Vehicle VI, the investment is tax-deductible; and investment earnings are tax deferred.
Comparison: When tax rates are constant over time, Vehicles V and VI are equivalent. Hence,
Accumulation in Vehicle VI dominates that for Vehicle I through IV as long as the tcg is not
0%.
If tcg = 0, Vehicles III & IV generate exactly the same after-tax accumulations as in Vehicle VI.

Slide 1Dominance Relations and Empirical Anomalies

15

Considering the previous 6 types of Savings Vehicles:

It is found that there are several strict dominance
relations among the savings vehicles, i.e., investors
would always prefer to avoid some of the savings
vehicles.
In the absence of frictions and restrictions, we would
never observe such tax-disfavoured vehicles as
Vehicle I (ordinary money market savings).
Yet, in the real world, money market savings command
a larger share of the savings than most tax-favoured
forms of savings.
The reasons stem largely from frictions and
restrictions.

Changes in Tax Rates over

Slide 1Time16

For pedagogical reasons, tax rates are assumed to be known and constant
and here, this assumption is relaxed.

Even without frictions and restrictions, the dominance relations among

savings vehicles disappear when we introduce intertemporal changes in tax
rates.

In this setting, Vehicles V and VI are no longer equivalent.

In particular, when tax rates are rising, Vehicle VI (pensions) become less
attractive and when tax rates are falling over time, Vehicle VI (pensions)
become more attractive.

Vehicle VI returns: [I.(1t0)].(1+R)n (1tn)

The subscript o indicates the tax rate in the period when the contribution is
made, assumed here to be the current period, and the subscript n indicates
the tax rate in the future period n when withdrawals are made.

When tn>t0, Vehicle V is superior. Conversely, when tn<t0, Vehicle VI is

superior.

Changes in Tax Rates over

Slide 1Time17

Vehicle VI returns: [I.(1t0)].(1+R)n (1tn)

When t0=50% and tn=28%, then
Vehicle VI return = 1.44(1+R)n
Thus, Vehicle VI provides an after-tax accumulation of
44% more than complete tax exemption.

When t0=31% and tn=40%, then

Vehicle VI return = .87(1+R)n
Thus, Vehicle VI provides an after-tax accumulation of
13% less than complete tax exemption.

End of the Chapter

Thank you.

Slide 118