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Prospect of declining returns a hard pill for savers to swallow

A hike in the capital gains inclusion rate would be quite distressing, but taxes already eat into returns in a big way.

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Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

There are no sure things in this world except death and taxes but, with a little luck, medical advances will allow death to take a long sabbatical. News on the tax front isn't as encouraging because rumours are rife that the upcoming federal budget will punch savers right in their portfolios.

Some speculate that the capital gains inclusion rate will surge from its current level of 50 per cent up to as much as 100 per cent. Such a move would be quite distressing because taxes already eat into returns in a big way.

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The situation can be explored by applying different tax rates to the returns generated by the S&P/TSX composite index, which is a broad measure of the Canadian stock market. The market climbed by an average of 6.1 per cent annually from the start of 2000 to the end of 2016, despite the crash of 2008. As a result, each dollar invested into it turned into $2.76 before taxes and other frictions.

Many analysts expect the market will continue to provide similar returns over the next decade or so. Naturally, some analysts are more bullish while others are more bearish. But long-term expectations remain fairly muted because the recent bull market is a little long in the tooth.

While taxes vary from person to person, the top marginal rate in Nova Scotia will be highlighted because it is the highest in the land. Mind you, several other provinces are closing in and seem eager to take the lead.

The top rate on interest income in Nova Scotia is a hefty 54 per cent and the top rate on capital gains is 27 per cent, according to Ernst & Young.

If you apply a 27-per-cent tax on gains annually, the stock market's annual growth rate falls to 4.5 per cent. That's not great, but investors can save money by holding stocks for longer than a year. On the other hand, the top tax rate on dividends is about 42 per cent and a good fraction of the market's gains come in the form of dividends, which haven't been factored in.

The bad news is just beginning because inflation also has to be accounted for. Inflation reflects the tendency for money to lose purchasing power over time. It is often considered to be another form of taxation.

Adjust the market's return for both tax and inflation and its annual growth rate falls to 2.6 per cent. Put in more concrete terms, a dollar's worth of purchasing power at the start of 2000 grew to $1.55 by the end of 2016, which hardly represents a home run for investors.

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Now consider a similar scenario but eliminate the break given to capital gains so that they are taxed instead like regular income at the top rate of 54 per cent. The market's after-tax return rate would fall to 2.9 per cent and its inflation-adjusted after-tax return rate would tumble to 1.0 per cent.

In other words, a dollar's worth of purchasing power would turn into just $1.18 over the course of nearly two decades. That seems like poor compensation for taking on a great deal of risk.

Naturally, these results are approximate. Not only do investors face different tax rates depending on their situations but the market's return would itself likely be affected by a big tax hike.

Nonetheless, the prospect of earning about 1 per cent on stocks will be a hard pill for savers to swallow. Even worse, the paltry rate does not include other costs such as fund fees or commissions. Add a 2.5-per-cent annual fund fee into the mix and the situation could become dire indeed.

Practically speaking, investors should try to minimize their tax bill with the help of their accountants. For most people that will mean fully utilizing their registered retirement savings plans and tax-free savings accounts. Those who don't may see the government snatch the lion's share of their returns before the Grim Reaper swoops in and levies an estate tax on the way out.

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About the Author

Norman Rothery, Ph.D., CFA, is the founder of StingyInvestor.com and has been catering to value investors since 1995. He publishes the Rothery Report, a value stock newsletter. Norm obtained a Ph.D. in atomic physics from York University before following his passion for investing. More

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