LOS e: Describe how investment return and investment horizon affect the tax impact associated with an investment.

Q1. An investor faces the periodic payment of investment income taxes. With respect to the relationship between investment horizon and investment return, the tax drag is:

A)   positively related to both the horizon and investment return.

B)   negatively related to both the horizon and investment return.

C)   positively related to the horizon and negatively related to the investment return.

Q2. If the tax rate is positive and there is periodic payment of investment income taxes, then which of the following relationships is most accurate?

A)   Tax drag = tax rate.

B)   Tax drag < tax rate.

C)   Tax drag > tax rate.

Q3. The tax drag from both longer investment horizons and higher investment returns:

A)   are unrelated, and each has a linear relationship with cash drag that is independent of the other.

B)   have a multiplicative effect, so that the tax drag increases rapidly as the investment horizon and the returns increase.

C)   have an offsetting effect, so the tax drag can be zero in some cases where the investment horizon and returns are greater than zero.

LOS e: Describe how investment return and investment horizon affect the tax impact associated with an investment. fficeffice" />

Q1. An investor faces the periodic payment of investment income taxes. With respect to the relationship between investment horizon and investment return, the tax drag is:

A)   positively related to both the horizon and investment return.

B)   negatively related to both the horizon and investment return.

C)   positively related to the horizon and negatively related to the investment return.

Correct answer is A)

Both a longer horizon and a higher return will increase the tax drag.

Q2. If the tax rate is positive and there is periodic payment of investment income taxes, then which of the following relationships is most accurate?

A)   Tax drag = tax rate.

B)   Tax drag < tax rate.

C)   Tax drag > tax rate.

Correct answer is C)        

Under the given conditions: tax drag > tax rate. This is because the tax rate is being applied periodically to a value (the taxable gain or investment income) that is increasing at a compound rate.

Q3. The tax drag from both longer investment horizons and higher investment returns:

A)   are unrelated, and each has a linear relationship with cash drag that is independent of the other.

B)   have a multiplicative effect, so that the tax drag increases rapidly as the investment horizon and the returns increase.

C)   have an offsetting effect, so the tax drag can be zero in some cases where the investment horizon and returns are greater than zero.

Correct answer is B)

They are multiplicative in the formula. Thus, when both are increased, the tax drag rapidly increases.