Body

23/06/2012 17:49

A Question of Priorities
People behave irrationally to avoid paying taxes Does it always pay to minimise your tax bills? Not necessarily. In fact, the reverse may be the case. If you pay too much attention to the tax element in your investment decisions, you may end up poor. Poor, as compared to those who do not let tax considerations dominate their investment decisions. I realise my view runs counter to popular perceptions. This column isn't called The Contrarian without reason. Of Death and Taxes A wise philosopher once said, "There are only two things that are inevitable in this world. One is death. The other is taxes." Most people dislike dying. That's understandable. I share that feeling myself. Most people don't like paying taxes either. This, I do not always understand. People go to crazy extremes to avoid paying taxes or at-least to minimise their tax bills. There seems to be an inner voice that tells every man or woman earning enough money: "Do something, anything, but try to reduce your taxes." Getting Your Priorities Right In their obsessive desire to avoid paying taxes, people display a confusion of priorities. Indeed, many of life's errors result from people forgetting what they were really trying to do. (As another wise philosopher once said, "Fanaticism consists of redoubling your effort, when you've forgotten your aim.") If you're one of those who is paranoid about saving taxes, ask yourself: What is it that you're aiming for: (1) Minimising your taxes?; or (2) maximising your post-tax, eventual net-worth? If you answered, "yes" to question (1) and "no" to question (2), stop reading right here. This article is of no use to you. In a letter to his partners, many decades ago, Warren Buffett asked the same questions. He wrote: "What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and ends should, never be confused, however, and the end is to come away with the largest after-tax rate of compound." The end, as Buffett puts it, is to earn the largest after-tax rate of compound. Meaning, that people should direct their capital towards assets that have good prospects of earning the highest post-tax rate of return with a minimum risk of loss of that capital. People's emotional distaste for paying taxes prevents them from behaving rationally while making investments. Here is an example: Tax Saving Schemes The Income Tax Act offers several tax saving schemes to taxpayers. Typically, these schemes require investment in specific fixed-income securities (such as National Savings Certificates, Government Relief
file:///Volumes/Data/sanjaybakshi/Dropbox/Personal%20Site/SB's%20Site/Sanjay_Bakshi/Articles_&_Talks_files/A_Question_of_Priorities.HTM Page 1 of 3

Body

23/06/2012 17:49

investment in specific fixed-income securities (such as National Savings Certificates, Government Relief Bonds and several others) on which the interest is exempt, in full or in part. In some cases, the government also allows an instant reduction in the current tax bill of the person making investments in these securities. Every year, usually around the last possible day, thousands of Indians get up, and rush to invest their money in these securities. Why do they do it? To save on their tax bills, you'll say. No doubt, you'll save on your tax bill if you invest your money in these securities. But have you, before investing in these securities, followed Buffett's advice? Have you, in other words, calculated the post-tax rate of return that you expect to earn because of your investment in these securities, and compared it with post-tax returns available elsewhere? Have you even considered the possibility, that maybe it will be better to ignore these incentives and invest in an asset that has a prospect of doing much better? I doubt it. Very few people do it. Most people automatically follow conventional wisdom of investing every year in tax saving schemes, without ever comparing the returns available elsewhere. But, if you really do this type of analysis, or hire a person who will do it for you, you will find that many tax saving schemes are not worth it at all. You will find that while investments made in these schemes will save taxes, you will be saddled with an investment for several years that earns mediocre after-tax returns. In other words, you will succeed in minimising your tax bill but fail in maximising your eventual net-worth. An Example Suppose, in 1980, you decided to ignore the tax saving schemes offered by the government at that time as well as for the next fifteen years. There would have been two consequences of this decision. One, because you ignored the tax incentives, you would have paid a higher tax bill every year for the next fifteen years. And two, since your capital was not blocked in low-return, fixed income securities specified by the government, you would have money available every year to invest wherever you wished. Suppose, every year you invested that money in an asset called Sensex. During the period 1980 to 1995, Sensex earned an annual pre-tax return of 26.13 percent. To convert pre-tax into post-tax, you will have to consider two taxes on your returns on investment in Sensex - taxes on dividends and taxes on capital gains. Taxes on dividends would have been quite low, simply because you would not have received much dividends. As for taxes on capital gains, they would arise only when you sell the asset. Since you were holding the asset at the end of 1995, there was no capital gain tax to be paid. By not doing the conventional thing of investing in tax saving schemes every year, you would have been far richer. Let's assume you sold your asset - the Sensex - at the end of 1995. You would have paid a capital gains tax at a rate which is somewhat less than the 20 percent rate applicable on long-term capital gains. That's because you would get the benefit of cost-inflation index. On the whole, you would have still come out far ahead than those who did the conventional thing of investing regularly in tax saving schemes. Please note, I am not suggesting that you should forget about all tax saving schemes offered by the government and buy stocks, instead. Rather, I am suggesting that you should not blindly invest in tax saving schemes, without looking for better alternatives elsewhere. If you do this exercise every year, you will find that sometimes it makes economic sense to invest in these schemes (for example, at the height of a bull market) and sometimes, it does not. You will also see how foolish it is to block capital for long periods of time earning mediocre rates of return, just to save on taxes. Conclusion
file:///Volumes/Data/sanjaybakshi/Dropbox/Personal%20Site/SB's%20Site/Sanjay_Bakshi/Articles_&_Talks_files/A_Question_of_Priorities.HTM Page 2 of 3

Body

23/06/2012 17:49

Warren Buffett looks at any potential investment from a dispassionate point of view. To him it does not matter how much tax he has to pay on the returns that he makes on an investment so long as the post-tax returns are attractive. More often than not, he finds it much more profitable to invest in equities, the returns on which are taxable, than to invest in tax friendly fixed income securities offered by governments. A government has its own priorities. One priority is to raise cheap capital from the public. A government also knows that people don't like paying taxes. Therefore, by offering tax breaks on investments in certain securities, it can generate sufficient demand for these securities. But what the government gives with one hand by way of tax breaks, its takes it away with the other by offering poor, or mediocre returns on these securities. Since many lay taxpayers do not understand the complexities involved, they gladly buy these securities, in order to reduce their tax bills. But, doing so imposes an opportunity cost on these investors. Their capital is blocked for several years in fixed income securities, offering mediocre returns. Their omission to consider investing in other, taxable securities that may offer far better overall returns, costs them real money in the long run. Investor should have their own priorities. For them, maximising their eventual net-worth should be the first priority. Saving on taxes, should be a priority only if it does not conflict with the first priority. Instead of rushing forward every year to make investments solely for tax savings, investors will do well if they look at any investment, from a dispassionate viewpoint, like Buffett does. If the potential post-tax returns are attractive, why crib about paying tax to the government? People are not the only ones who do irrational things to save taxes. Many companies are equally irrational, or even more so, in trying to save on taxes. By doing so they hurt the interests of their shareholders. This is a topic that I shall cover in my next week's column. Note This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited. Sanjay Bakshi. 1997.

file:///Volumes/Data/sanjaybakshi/Dropbox/Personal%20Site/SB's%20Site/Sanjay_Bakshi/Articles_&_Talks_files/A_Question_of_Priorities.HTM

Page 3 of 3