Question

Explain how the combination of taxes and inflation reduces returns on financial investments.

Answer 1

Taxes are paid to the government out of the income earned. Taxes could be on interest, dividends, or capital gains. Most jurisdictions tax these returns in some way or the other. Thus, the net returns earned by investors (after-tax returns), are lower than the gross returns (pretax returns).

Inflation is the increase in general price levels in an economy. Inflation reduces the purchasing power of money over time. The real rate of return is the nominal rate of return, adjusted for inflation. Thus, the real rate of return earned by investor is lower than the nominal rate of return.

The combined affect of taxes and inflation, thus greatly reduces the actual return earned by investors.