# Class Notes Tax Essay

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Class notes and problems—Tax rates Problem You can invest in fully taxable bonds, stocks, or tax exempt bonds. You observe the following risk adjusted rates of return: Fully taxable bonds, 8.0%, Stocks, 7.0%, and Tax exempt bonds 6%. You use the pretax return to fully taxable bonds as a benchmark to calculate explicit and implicit taxes for each of the different investment alternatives. You use the fully taxable bonds as the benchmark asset. a. What is your best estimate of the explicit tax rate on returns to fully taxable bonds? Implicit tax? Total tax? Explicit tax rate (.08-.06) / .08 = .25 + Implicit tax rate (.08-.08) / .08 = 0 = Total tax rate .25 b. What is your best estimate of the explicit tax rate on returns to stock? Implicit tax? Total tax? Explicit tax rate (.07-.06) / .08 = .125 + Implicit tax rate (.08-.07) / .08 = .125 = Total tax rate .25 c. What is your best estimate of the explicit tax rate on returns to tax exempt bonds? Implicit tax? Total tax? Explicit tax rate (.06-.06) / .08 = 0 + Implicit tax rate (.08-.06) / .08 = .25 = Total tax rate .25 Assume the pretax rate of return on fully taxable bonds is 8%, stocks is 7%, half of which is taxable, tax exempt bonds is 6% Calculating indifference points * At what personal tax rate are you indifferent between holding fully taxable bonds and stocks, i.e., at what explicit tax rate will you earn the same after-tax rate of return? .08-.08t=.07-.07*.5t, t=.2222 * At what personal tax rate are you indifferent between holding stocks and tax exempt bonds, i.e., at what explicit tax rate will you earn the same after-tax rate of return? .07-.07*.5t=.0645, t=.2857 * If your tax rate is 20% do you want to own fully taxable bonds, stocks, or tax exempt bonds? FT bonds * If your