Tax & Inflation Effect on Investment

Financial independence is everyone’s dream and one way to achieve it is by investing in different types of products like mutual funds, fixed-income securities, shares, and much more.

You may often look for different options to determine the returns offered by various investment products. However, you may not know that these earnings are nominal returns and not the actual money you will receive in your pocket. Well, your return on investment is affected by inflation and taxes. Read on to know more.

What Is Inflation?

You may have heard this term frequently but do you know what is inflation rate? In simple terms, inflation means the rising living cost over a period or the lower value of money.

It is the general increase in the price of goods and services over the years, which decreases your purchasing power. For example, the price of a movie ticket five years ago was significantly lower than what it is today.

So, if the inflation rate is 2% and the movie ticket costs INR 100 today, its price one year later will be INR 102.

What Is Inflation Rate?

The retail inflation based on the Consumer Price Index (CPI) reduced to 5.59% in July 2021 against one year ago when it was recorded as 6.69% in August 2020.

The current inflation rate in India is between 2% and 6%, which is within the range of the Reserve Bank of India (RBI).

Types of Inflation

Inflation is a quantitative measure of changes in prices of goods and services over a period and is denoted as a percent. As inflation increases, the purchasing power decreases and vice versa.

Here are the 3 types of inflation.

1. Demand-pull inflation: It results when the demand for the goods and services exceeds their supply, and this difference results in a price increase.
2. Cost-push inflation: It is the result of the increase in production costs due to rising input prices like those of labor and raw materials.
3. Built-in inflation: It is the effect of future expectations; higher prices result in more wages, which offer better living standards, thereby continuing the cycle

Inflation Effect on Investment

The effects of inflation are not limited to lower purchasing power. It may result in the demand for higher wages to meet rising prices, which may mean more unemployment due to lay-offs.

High inflation can also weaken the country’s currency and make domestic products less competitive in the global markets.

What Is Nominal Rate of Return?

When you invest in any asset class, the potential returns are always nominal as these are calculated before tax and inflation. The nominal rate of return is the profit on your investments before considering factors like inflation, investment fees, and taxes.

Therefore, when you say that your investment returns are 10%, it actually means the nominal return is 10%. Comparing nominal returns of different asset classes helps you make the right investment decision as tax implications for every financial instrument may vary.

Nominal Rate of Return Calculation

The formula to calculate nominal return is as follows:

(End Value – Begin Value) / Begin Value

Let us understand this with an example, assume that you invested INR 10 lakh one year ago and its value today is INR 11 lakh, the nominal return is as follows:

(1100000 – 1000000)/1000000 = 100000, which is 10% returns on your initial investment

What Is After-Tax Real Rate of Return?

The post-tax earnings are the returns after adjusting for the tax implications on the profits.

Generally, the tax implications vary from one asset class to another and are also dependent on the investment horizon, age, and income tax slab.

After-Tax Real Rate of Return Calculation

The after-tax real rate of return is calculated as Nominal Rate of Return x (1 – Tax Rate)

Let us take the above example, where the nominal rate of return was 10%. Now assume that the applicable tax rate is 20%. The after-tax returns will be 10% x (1 – 20%) = 8%

What Is Tax Rate?

It is the rate at which the tax liability is calculated on your income. Below are the tax rates for individuals as per the old and new tax regime:

What Is Cess?

Do you know what is cess? A cess is a tax levied by the government on taxes for specific purposes until the authorities receive the required funds to meet their purpose.

It is different from the regular tax levied on your income and is a tax on the tax. The regular tax collected by the department is retained in the Consolidated Fund of India (CFI) and can be used for any purpose as required.

On the other hand, the revenues collected as cess are first credited to the CFI and after the appropriation from the Parliament, the government may use it for its deemed purpose.

Another difference between regular tax and cess is that the former is shared with the state governments while the latter may or may not be shared with the state governments.

The various types of cess on income tax that may be levied by the government include education, health, clean energy, Krishi Kalyan, and Swachh Bharat cesses.

How to Calculate Post-Tax Returns?

The post-tax returns on investments are calculated after considering the implication of cess on the actual tax.

For example, if the cess is levied at 4%, then the post-tax return calculation is as follows:

Nominal Return = INR 100000

Tax @ 20% = 100000 x 20% = INR 20000

Cess @ 4% = 20000 x 4% = INR 8000

Post-tax returns = 100000 – 20000 – 800 = INR 79200, which is 7.92%

What Is Real Rate of Return?

As discussed above, inflation erodes the value of money. Therefore, the value of INR 1 lakh today is not the same as it was one year ago.

To know the actual profit, you earn on your investment, calculating the real returns is recommended.

The real rate makes the necessary adjustments on the profits for the effects on inflation and is an accurate measure of your actual earnings.

Nominal returns are generally higher than the real rate of returns except when inflation is zero or in the case of a deflating economy.

Real Rate of Return Calculation

Let us understand how to calculate the real returns with an example. Assume that you have saved INR 1,00,000 to pay for a new car, but you decide to invest it in a fixed deposit for one year that provides a 5% rate of interest.

On maturity, you will receive INR 1,05,000 on the deposit. Now consider that the rate of inflation during the year is 3%, which means the car now costs INR 1,03,000.

Therefore, after paying for the car, you will be left with INR 2000 on your initial investment of INR 1,00,000, giving you real returns at 2% against the nominal fixed deposit interest rate of 5%.

The real rate of return formula is [(1 + after tax rate) / (1 + rate of inflation)] – 1

How to Calculate Absolute Return?

Absolute return is the absolute profit or loss earned on your investments over a certain period. The profit or loss is generally shown as a percentage of the total investments.

The formula for calculating absolute return:

[(Current Value – Purchase Value) / (Purchase Value)] x 100

If you invest INR 20 lakhs in a property today and sell it for INR 25 lakhs after two years, the absolute return will be [(2500000 – 2000000) / 2000000] x 100 = 25%

What Is Actual Profit?

When you invest in different assets, you may study the historical returns, which are the nominal returns delivered by these products over a period.

However, inflation and tax are real and affect your actual returns. The actual earnings are those that are adjusted for inflation and tax and are the amount that you will receive in your pocket.