# Using Effective Tax Rates to Compare Investments



## Sarenco (24 Mar 2015)

We have debated this issue across a number of threads but Brendan asked me to set out my argument in a separate thread.

By way of a simple example, let's assume an investor with PAYE income of €33,800 and net rental profits of €4,000.  Let's further assume that the investor earns €4,000 gross interest on his cash deposits.

It is obviously the case that every Euro of income above the relevant ceiling will attract income tax at the marginal rate, plus USC and PRSI at the applicable rates.  In the case of a single person without dependant children, that means that every Euro of income above €33,800 will be subject to income tax at a rate of 40%, plus PRSI at a rate of 4%, plus USC at a rate of 7% (i.e. a combined, headline rate of 51%).

On this basis, the common perception is that the net rental profits in the above example are taxed at a rate of 51% (the headline rate), whereas deposit interest is only taxed at a rate of 45% (i.e. DIRT at a rate of 41%, plus PRSI at a rate of 4%).

However, in my opinion it is more accurate to use the average (or effective) rate of income tax that applies across an investor's total income, rather than using the headline rate, when comparing investment income that is subject to income tax (such as net rental profits) and investment income that is subject to a flat rate of tax (such as deposit interest). 

In preparing the investor's tax return, the PAYE income and net rental profits are aggregated and the total amount is then taxed on a tiered or progressive basis, having applied the appropriate credits and reliefs.

The investor is not taxed at one rate on net rental profits and a different rate on his salary - he is taxed on a blended basis on his composite income (i.e. the different sources of taxable income are entirely fungible). As such, it is more accurate, in my opinion, to use the average (or effective) tax rate on all taxable income in contrasting the taxation of the €4,000 in net rental profits with the €4,000 in deposit interest.

In the example above, the effective income tax rate is likely to be around half the headline rate (the precise rate will depend on reliefs claimed). 

In contrast, DIRT is levied at a flat rate on all €4,000 of the deposit interest. DIRT is not levied on a progressive or tiered basis and therefore the effective tax rate on the gross deposit interest (including PRSI) is simply 45%.


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## Gordon Gekko (24 Mar 2015)

Why would you do that? It makes no sense.

If someone is taxed at the top rates of income tax, PRSI and USC and they're assessing a potential investment, effective rates are irrelevant. The investment income will be taxed at those top rates - That's all that's relevant.

Say I'm paid €100k a year and my employer asks me whether I'll do something for a €100k bonus. When deciding whether to do it or not,  it's the net €48k that I'll think about. Why would I consider the effective rate that would be applicable to my entire €200k? It's just not relevant.


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## Itchy (24 Mar 2015)

Its really only relevant when your return will bring you from the the lower rate to the higher rate of tax. And the absolute value of the return at those levels is probably small. But yeah use any method you like to compare investments, its all relative!


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## Sarenco (24 Mar 2015)

Gordon Gekko said:


> Why would you do that? It makes no sense.
> 
> If someone is taxed at the top rates of income tax, PRSI and USC and they're assessing a potential investment, effective rates are irrelevant. The investment income will be taxed at those top rates - That's all that's relevant.
> 
> Say I'm paid €100k a year and my employer asks me whether I'll do something for a €100k bonus. When deciding whether to do it or not,  it's the net €48k that I'll think about. Why would I consider the effective rate that would be applicable to my entire €200k? It's just not relevant.



It's obviously the case that any income taxed above the relevant ceiling is taxed at a higher rate.  

I'm simply pointing out the difference between the effective tax on an investment that is subject to tax on a progressive or tiered basis and the effective tax rate on an investment that is subject to a flat rate of tax.  

This point has nothing to do with whether or not you would choose to add to income that is subject to tax on a progressive basis - it relates to choosing between investments that are subject to different tax regimes.


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## Sarenco (24 Mar 2015)

Itchy said:


> Its really only relevant when your return will bring you from the the lower rate to the higher rate of tax. And the absolute value of the return at those levels is probably small. But yeah use any method you like to compare investments, its all relative!



Well, it's certainly all relative!

Where the distinction comes most sharply into focus is in circumstances where an investor has a relatively modest level of taxable income but has relatively substantial assets.  

A good example would be a retiree who has received a lump sum from a pension scheme and is deciding between investing in directly held dividend stocks (where the dividends are subject to income tax) or a high yield equity fund (where the dividends are typically subject to exit tax at a flat rate).  Alternatively, the decision might be between paying down a mortgage on a rental property (thereby increasing net rental profits that are subject to income tax) or putting the lump sum on deposit (subject to DIRT at a flat rate plus PRSI).

For high earners, the difference between the effective tax rates on these investments will certainly be less pronounced and a flat rate of tax may actually be beneficial for particularly high earners.


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## Brendan Burgess (24 Mar 2015)

Hi Sarenco 

I think you have to look at a particular decision, to see which is the best approach to use.

The issue seems to have arisen when assessing decisions on investment properties. 

Let's say I have a home worth €500k and a mortgage of €400k on an SVR of 4% 
I have €200k in cash and I have to decide whether to buy an investment property or pay down my mortgage. 
I have a PAYE income of €50k so my marginal rate is 51% and my effective rate is, say, 30%. 

This is how I would do the calculations 

Pay €200k off mortgage: Actual return on my money is €8,000 a year (4% of €200k) 

Invest in a property with a rental profit before tax of 6%.  
Rental profit €12,000
Actual tax paid on this profit @51%: €6,000 
Actual return on my money: €6,000

Therefore it's clearly better on this basis to pay down my mortgage. 

How would you approach this decision?


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## Sarenco (25 Mar 2015)

Brendan Burgess said:


> Hi Sarenco
> 
> I think you have to look at a particular decision, to see which is the best approach to use.
> 
> ...



Hi Brendan

I would use the effective tax rates (30% versus zero in your example) to compare the after-tax returns of both options.

Mind you, a net rental yield of 6% (before tax and financing costs) implies a gross yield of around 9%, which would be pretty impressive outside a fairly high-risk area from an investment perspective (the current nationwide average gross yield is around 6% per Ronan Lyons).

As always, it comes down to a risk/reward trade-off.  Your example compares a guaranteed, after-tax return of 4% (by paying down the mortgage on the PPR) versus a risky, after-tax return on the rental property of 4.2% (70% of your 6% net yield).  Given that choice, I'd take the guaranteed 4% return every time!


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## Brendan Burgess (25 Mar 2015)

Sarenco said:


> I would use the effective tax rates (30% versus zero in your example) to compare the after-tax returns of both options.



Sarenco

I think if you do out the actual numbers as I have done, it will help you to explain the issues to us better. I think that you are making errors or reasoning, because you are working in abstract yields rather than in hard cash. 

Brendan


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## Sarenco (25 Mar 2015)

Sorry Brendan but on re-reading your example, it has just struck me that the effective rate of 30% only related to PAYE income.  Adding €12k of rental profit to the €50k of PAYE income would increase the effective rate on the aggregate amount to 34% (€50k @ 30% plus €12k @ 51% = €21,120, which is roughly 34% of €62k).

So using your calculation framework:-

Pay €200k off mortgage: Actual return on your money is €8,000 a year (4% of €200k)
Invest in a property with a rental profit before tax of 6%.
Rental profit €12,000
Effective tax rate of 34%: €4,080
Actual return on your money: €7,920

So paying off the mortgage on the PPR comes out marginally ahead on this basis.  However, more importantly the return of €8,000 by paying down the mortgage is guaranteed whereas the projected after-tax profit on the rental of €7,920 is far from guaranteed.

Hope that makes sense.


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## Brendan Burgess (25 Mar 2015)

You have to leave aside the issues around projected rental profit being guaranteed. Assume it is guaranteed to focus on the key issue here which is your approach to analysing such problems.

This will be your tax return at the end of the year:



The use of average tax on the rental income is just irrelevant and could lead you to a misleading answer. 

The return on your money will be €6,000 if you buy a property. You are overstating it by almost €2,000 using average rates. 

Brendan


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## Sarenco (25 Mar 2015)

But have you not used effective rates in your examples?  €50k @ 30% plus €12k @ 51% = a total tax liability of €21k or, to put it another way, an effective rate of just under 34% on a total income of €62k.  Incidentally, 30% of €50k is €15k (not €20k).

Again, I emphasise that I am not arguing that the top "slice" of income above the relevant ceiling is not subject to tax at the headline rate.  If you want you can think of the net rental profits as the "slice" of income that is subject to the highest rate of tax but you could just as equally think of it as the "slice" that is subject to the lowest rate of tax - Revenue will tax you on an aggregate basis regardless. 

I also agree that in this case, it makes no difference to the bottom line net figure because in buying the rental property you are choosing to add to income that is already subject to tax on a progressive basis above the applicable ceiling versus paying down debt which is neutral from a tax perspective.

In any event, my original post was focused on the difference between the effective tax on an investment that is subject to tax on a progressive or tiered basis and the effective tax rate on an investment that is subject to a flat rate of tax.


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## Brendan Burgess (25 Mar 2015)

I think that the way I set it out explains how to answer such questions. 

It makes the financial aspects of the decision clear. 

In fact, there is no need at all for the information on the current salary and average tax rate - once a person is paying the marginal rate of tax, you must use that in any assessment. 

Brendan


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## Gordon Gekko (25 Mar 2015)

Sarenco said:


> It's obviously the case that any income taxed above the relevant ceiling is taxed at a higher rate.
> 
> I'm simply pointing out the difference between the effective tax on an investment that is subject to tax on a progressive or tiered basis and the effective tax rate on an investment that is subject to a flat rate of tax.
> 
> This point has nothing to do with whether or not you would choose to add to income that is subject to tax on a progressive basis - it relates to choosing between investments that are subject to different tax regimes.



Effective tax rates just aren't relevant here - They just confuse things.


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## Sophrosyne (25 Mar 2015)

Looking at Sarenco's first post, I think the issue is whether to buy a rental property or whether to invest the money some other way and how that would affect after tax income.

It might be more useful to compare someone who had a salary of €50,000 + a rental profit of €12,000 and another who had a salary of €50,000 and deposit interest of €12,000.

The obvious difference is that deposit interest is not subject to USC.

However, whether the investment would achieve the same deposit interest as rental income is probably more relevant.


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## Sarenco (25 Mar 2015)

Sophrosyne said:


> Looking at Sarenco's first post, I think the issue is whether to buy a rental property or whether to invest the money some other way and how that would affect after tax income.
> 
> It might be more useful to compare someone who had a salary of €50,000 + a rental profit of €12,000 and another who had a salary of €50,000 and deposit interest of €12,000.
> 
> ...


 
Thanks Sophrosyne - that's exactly what I am trying to tease out.

If you use Brendan's formula and simply use the marginal rate you would conclude that the after-tax rental profit is €5,880 (€12,000 less 51% tax) and the after-tax deposit interest is €6,600 (€12,000 less 45% tax).

If you use effective rates of tax, you would conclude that the after-tax rental profit is €7,920 (€12,000 taxed at an effective rate of 34%) and the after-tax deposit interest is €6,600 (€12,000 taxed at an effective rate of 45%).

No?


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## Gordon Gekko (25 Mar 2015)

But the effective rate of tax is irrelevant!

Rental income person is paid €12k by their tenant and then ponies up €6,120 in tax (51%) leaving them with €5,880.

Deposit interest person is paid €12k by their bank but loses €5,400 to the taxman (45%) leaving them with €6,600.

Forget tax - Just think of the cashflows.


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## Sarenco (25 Mar 2015)

Gordon Gekko said:


> But the effective rate of tax is irrelevant!
> 
> Rental income person is paid €12k by their tenant and then ponies up €6,120 in tax (51%) leaving them with €5,880.
> 
> ...




Fair enough but I'm not suggesting that the cash flow position will change.  

I am focused on expressing the relevant tax in % terms so that a fair apples-to-apples comparison applies if a decision is made to use cash on deposit to pay down a mortgage on a rental property (thereby increasing the amount that is subject to income tax and decreasing the amount that is subject to DIRT).


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## Mrs Vimes (26 Mar 2015)

Hi Sarenco,

Interesting discussion.

I think the confusion stems from the fact that your calculations using the effective rate of tax neglects to take account of the fact that the presence of rental income increases the effective tax rate which the investor pays on *all* his income.

It would be more correct to calculate tax payable with and without the presence of rental income, work out effective rate with and without, apply the 2 effective rates and then work out the actual tax payable with and without rental income.

Since the marginal rate will always be the answer it is just a lot easier to ignore effective rates entirely and just use marginal rate.


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## Sophrosyne (26 Mar 2015)

Sarenco said:


> Thanks Sophrosyne - that's exactly what I am trying to tease out.
> 
> If you use Brendan's formula and simply use the marginal rate you would conclude that the after-tax rental profit is €5,880 (€12,000 less 51% tax) and the after-tax deposit interest is €6,600 (€12,000 less 45% tax).
> 
> ...



I'm afraid not.

Using Brendan's example, the additional tax payable is €6,120 leaving an after tax gain of €5,880.

The effective rate on the gross income is 33.74%.

This does not mean that the €12,000 rental income should be taxed at 33.74%, but rather that the tax rate averaged on €62,000 is 33.74%.

Brendan's example was easy to work out as the lower rates of income tax and USC were used up by the salary.

In other cases you might have to take account of unused portions of lower rates.

That said, your point regarding incomes subject to progressive rates and incomes subject to flat rates is legitimate.


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## Sarenco (29 Mar 2015)

Mrs Vimes said:


> Hi Sarenco,
> 
> Interesting discussion.
> 
> ...




Thanks for your feedback Mrs Vimes.

You are, of course, quite correct that the difference between the effective tax rate on the income, ex-rental income (30% in Brendan's example above) and the effective rate on the aggregate income (34% in this example) equates to the headline rate (51%) on the differential.  This would not be the case if the rental income straddled one or more tax brackets (bearing in mind that different ceilings apply to income tax, USC and PRSI).

My difficulty is that this would appear to inevitably treat the rental income as the top "slice" of income that is subject to the headline rate of tax for no particular reason.


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## Sarenco (29 Mar 2015)

Sophrosyne said:


> I'm afraid not.
> 
> Using Brendan's example, the additional tax payable is €6,120 leaving an after tax gain of €5,880.
> 
> ...



Hi Sophrosyne

Yes, I am conscious that ~34% in this example represents the effective tax rate on the aggregate income and not the rental income alone.

I don't really see why you would treat the PAYE income alone as having benefited from tax credits and having used up the lower tax rates - you could just as well have treated the rental income as having these benefits.


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## Gordon Gekko (29 Mar 2015)

Sarenco said:


> My difficulty is that this would appear to inevitably treat the rental income as the top "slice" of income that is subject to the headline rate of tax for no particular reason.



No, it's for reasons of logic and chronology. There's existing income on to which rental income is being added. Doing anything other than looking at the marginal rate (i.e. the rate that the income will be subject to) makes no sense at all.


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## Brendan Burgess (29 Mar 2015)

Sarenco said:


> My difficulty is that this would appear to inevitably treat the rental income as the top "slice" of income that is subject to the headline rate of tax for no particular reason.





Sarenco said:


> I don't really see why you would treat the PAYE income alone as having benefited from tax credits and having used up the lower tax rates - you could just as well have treated the rental income as having these benefits.



Hi Sarenco


I presume you have no argument with the principle in  my example?

It's actually a fairly simple decision making process.  It's a marginal decision - in the sense that only marginal issues are relevant.

But, at this stage, it's your problem. You have a blind spot, which you will  have to deal with yourself. Quite a few of us have spent a considerable effort trying to help you see through this, but we have failed.

Brendan


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## Sophrosyne (29 Mar 2015)

Hi Sarenco,


I think you problem lies with averaging.


However, this article may help you understand the principle.


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## Sarenco (29 Mar 2015)

Sophrosyne said:


> Hi Sarenco,
> 
> 
> I think you problem lies with averaging.
> ...



Many thanks for that link Sophrosyne - that's exactly the sort of analysis that I was looking for.

So the correct rate to apply is calculated by dividing the amount of additional taxes that will be due as a result of some decision by the amount of income involved.  Depending on a taxpayer's individual circumstances, this rate could be anywhere between 0% and 55% as things stand.  

Blind spot corrected!


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