Results of three studies examining investment returns show that, in aggregate, investors with tax rates above 23% received higher returns from tax-exempt securities than from taxable investments over the last nine years. The annual return advantage for taxpayers in the top tax bracket (35%) was approximately 0.26%.
While the results of the studies generally favored a tax-exempt investment mandate, taxable securities outperformed in 26% of the examined time periods, leaving possible room for outperformance if an investment mandate takes a blended approach.
It appears that the tax-exempt security’s yield advantage occurred in a low yield environment. After peaking in mid-2005, this advantage steadily diminished as interest rates rose.
Please note that these studies’ return comparisons include market indices that may not adequately address the actual supply-and-demand dynamics of the respective markets. For effective tax-sensitive investing, investors should also consider the technical aspects of tax-exempt investments, such as reduced market liquidity, limited supply and municipal funding fluctuations.
Profitable corporations and other taxpaying entities naturally need to consider cash and short-term investments in their overall tax management strategies. From time to time, as shown by empirical and anecdotal evidence, the treasury management community may fail to fully appreciate the tax implications of short-term investment returns.
One common mistake is the tendency to purchase taxable securities even though a tax-exempt investment mandate could result in higher after-tax returns. A 2006 survey by the Association for Financial Professionals revealed that municipal securities accounted for less than 9% of short-term allocation, even though 46% of the respondents allowed municipal notes, 28% allowed variable rate demand notes, and 35% allowed auction rate notes in their investment policies. Similarly, a taxpaying investor should avoid the potential mistake of requiring a tax-exempt mandate and excluding all taxable securities from the portfolio.
In response, we conducted a performance evaluation of several comparable short-term investment vehicles to demonstrate the after-tax return differentials between taxable and tax-exempt mandates. By introducing the concept of a “breakeven” tax rate, we hope to provide a simple tool for investors to use when incorporating investment policy decisions into their overall tax strategies. Please note that, in the marginal income tax rate system of the U.S., the breakeven rate is the top tax rate, not the average tax rate.
We acknowledge that corporate income taxation is a complex subject and is an area in which we are not experts. This study focuses strictly on comparative index returns. We also recognize that the return objective of cash portfolios is typically a subordinate consideration to capital preservation and liquidity management.
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