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