Stock market rolling diceIt’s no secret that the financial services industry is viewed with great distrust. Recently, a guest lecturer who works in the insurance industry told our class that government, banks, and insurers are (somewhat unsurprisingly) the three least-trusted institutions in the country. Particularly in light of the financial crisis of 2007-08, asset managers, financial advisors, brokers, and others in the financial services have come under fire for being excessively ‘risk-seeking’.

The reality of any sort of financial management or investment is twofold:

1) There is almost always a trade-off between risk and return, where higher returns are generally accompanied by greater risk; and

2) People tend to be risk- or loss-averse, especially with regards to their money.

It’s true that some investors engage in market speculation and make huge monetary bets, simply because they have a high tolerance for risk and are hoping to earn excess returns. This is not the case for the majority of investors, though. Financial prudence is very important for many of the largest players in the financial markets, such as pension funds and insurers.

But regardless of whether a given investor is more risk-seeking, or another is more risk-averse, certain factors will lead both to make riskier investment decisions. Here we will consider one of the most significant systematic factors, after some important context is given.

Investment objectives

All investors have objectives: their own, if they are managing their own money, or those given to them by someone else whose assets they are managing.

Pension funds, for example, need to provide fund members with a stream of payments upon retirement – one that is adequate to members’ needs. This objective must be met by taking regular pension contributions and properly investing them in various financial assets. Insurers are another example. They need to make provisions for payments on events such as death, disability, theft, damage to property, and so on. As with pension funds, insurers invest the incoming cashflows, ie. the premiums from clients.

When deciding how to invest, investors will seek assets that provide income or returns in line with their primary objectives. With this in mind, we can now consider that crucial, aforementioned systematic factor.

Insights from Makeham’s formula

Shown below is a generalisation of something called Makeham’s formula. Those with an aversion to mathematics need not worry, though, because the analysis here is not going to be very technical – in fact, it should be quite intuitive.

 

Makeham's formula
Makeham’s formula, accounting for the effects of income and capital gains taxes

Makeham’s formula can be used to place a value on a financial asset (with this ‘value’ represented by A on the left-hand side, above). The formula takes into account the various cashflows that would arise due to owning the asset. In the case of a bond, these would be the coupon (‘interest’) payments and the principal (the outstanding loan amount); for equities, these could be dividend income and the potential selling price at a future date.

Our focus here is only on two symbols: t1 and t2. These represent taxes on investment income and capital gains, respectively. Notice the minus signs before these symbols in the formula, as indicated.

Income and capital gains taxes have the net effect of decreasing the cashflows received by the holder of a given asset – after all, tax involves money being taken away from the person who has earned it. If all income from the asset is affected by tax, then higher income and capital gains tax rates necessarily mean that the asset’s value is lower, because the investor will receive less money in future than they otherwise would have; this should be quite intuitive.

When investors determine how to achieve their objectives, they take tax into account.

If they require R100 after the investment period, and all proceeds are taxed at 9.1%, then it’s not sufficient to buy an asset that generates R100 over its life – the investor would be left with R90.90 after tax, which would fall short of their goal. Instead, they would need to buy an asset that generates R110, so as to have R100 after tax.

Conclusion

As was stated at the outset, there is an important trade-off between risk and return. An asset that generates R110 will do what our hypothetical investor requires, but will almost certainly be a riskier one to own than that which generates R100. It should be clear at this point that taxes on assets compel investors to make riskier decisions – and the higher those taxes go, the more risk they have to assume.

It’s all well and good to blame the financial sector for ‘risky’ behaviour, but attention is seldom given to one of the key drivers of such behaviour. Taxing the income and capital gains on assets is a deliberate policy, and its consequences are very much real, even if they aren’t intended.

Perhaps next time we hear some government official lecturing the country about ‘greed’ or ‘risk-taking’ in the financial markets, someone should point out that there is something that the government can do to help fix that: drop the taxes on investments.

An ardent supporter of personal responsibility and freedom, Nic enjoys thinking and writing about all sorts of things: economics, Critical Theory, culture, and current affairs. He is a fourth-year actuarial science student at the University of Cape Town.
Favourite economist: Mises or Rothbard.
Favourite political philosopher: Thomas Sowell