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Taxation

A

Ayushi Arora

Member
Hi, I am not clear with one of the example which is part of course notes.
I am adding the example here:
In a particular market there are two investors. Investor A is subject to tax at 50% on income and 20% on capital gains. Investor B is subject to tax at 40% on income and 30% on capital gains. There are also two types of investment available, each offering a similar total pre-tax return and similar features, except that: • Investment X provides a low level of income • Investment Y provides a high level of income. Assuming that Investors A and B have similar levels of wealth and that the quantity of Investment X available is similar to the quantity of Investment Y, which type of investment is Investor B likely to choose?

I am clear with the logic behind both Investors preferring Investment X. However not clear how Investor A willing to pay more for Investment X makes Investor B choose Investment Y instead of Investment X. Please Explain this.

Thanks
Ayushi
 
Hi from what I understand:

The quantity of investment X is similar to the quantity of investment Y, so the notes are assuming that the market capitalization is limited.

Investor A is taxed heavily for income at 50% relative to investor B. Investor A is also taxed more leniently for capital gains at 20%, than compared investor B. For investor A, the difference between capital gains and income tax is 30%, and for investor B the difference between capital gains and income tax is only 10%.

This means that investment X is much more valuable to investor A than compared to B. Due to this, investor A will demand investment X to such an extent that it will bid up the price in the market (since A is more heavily affected by income tax, relative to capital gains tax). The price might be increased to such an extent that investor B, might not perceive it as worthwhile to purchase investment X at its new increased price (since they are somewhat taxed the same for capital gains and income), so after doing some cost-benefit analysis, they might reach the conclusion that investment Y is more tax efficient.

Hope this helps
 
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