lose 31 basis points per year compared with the after-tax return that
would result if the inflation rate were zero. If the inflation rate rises to 6
percent, the decline in annual return is more than 65 basis points per
year. I call this effect the “inflation tax.” The inflation tax for various in-
flation rates and various holding periods under the current tax system
are displayed in Figure 5-3.^5
The inflation tax has a far more devastating effect on after-tax real
returns when the holding period is short than when it is long. This is be-
cause the more frequently an investor buys and sells assets, the more fre-
quently the government can tax the capital gains. But even for long-term
investors, the inflation tax reduces after-tax returns.CHAPTER 5 The Impact of Taxes on Stock and Bond Returns 71
(^5) Figure 5-3 assumes a total real return of 7 percent (real appreciation of 5 percent, a dividend yield
of 2 percent), and tax rates of 15 percent on capital gains and dividend income. If inflation is 3 per-
cent, the total before-tax return on stocks will be 10 percent in nominal terms.
FIGURE 5-3
Impact of Holding Period on Real After-Tax Returns
0%
1%
2%
3%
4%
5%
6%
7%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20 %
Inflation Rate
Real After-Tax Return
1-Year Holding Period
5-Year Holding Period
10-Year Holding Period
20-Year Holding Period
30-Year Holding Period
50-Year Holding Period