The 7 Tested Tax Regimes
The CFA Level 3 curriculum breaks taxes down into three main systems which are further grouped into seven individual tax regimes. Each of the three systems is defined by how it levies taxes and each of the seven regimes is characterized by how they tax income, capital gains, and dividends respectively (which ties back to the tax principles you need to keep in mind for the exam).
The L3 exam could ask you to identify which tax regime is in effect based on details in a passage or to identify under which regime a particular investment strategy is most likely to perform well.
The 3 Tax Systems You Need to Know for CFA Level 3
The three tax systems are:
- Income taxes
- Wealth based taxes
- Consumption taxes (VAT)
Income taxes are levied on what you earn. This could include your wages, interest income, dividend, capital gains, etc. The seven progressive regimes are all about whether they give tax advantages to these different income streams.
Wealth-based taxes are essentially a flat fee tax structure. A wealth based tax is assessed on the total wealth that you have. Where an income tax rate could be 30-50%+ a wealth based tax is generally a very small percentage of one's overall wealth (1-2%).
Finally we have consumption taxes or value-added taxes (VAT). These refer to taxes that are added to anything that you purchase. Because the more you consume the more you are taxed this system is generally thought to be quite progressive.
Each of these three systems is deisgned (obviously) to collect tax revenue but also to encourage or discourage certain behaviors. For example, a wealth based tax theoretically makes it harder to amass a huge estate, consumption taxes should be higher for the wealthy, and income taxes can be designed to encourage different incentives (like saving more for retirement by having a lower tax rate on long-term capital gains).
Summarizing Income, Wealth, and Consumption Taxes
The 7 Global Tax Regimes
The CFA Institute introduces seven global tax regimes on level 3.
- Common Progressive
- Heavy Dividend Tax
- Heavy Capital Gain Tax
- Heavy Interest Tax
- Light Capital Gain Tax
- Flat & Light
- Flat & Heavy
You need to be familiar and able to distinguish between all seven of these based on how they treat ordinary income, dividends, and capital gains:
As you can see by this table each regime is separated based on how they treat ordinary income, dividends and capital gains. They all have some variation in the structure of tax levied on these.
First of all, you should know that:
- A progressive tax rate structure means that the tax rate increases as income grows.
- A flat tax structure means that all taxable income is taxed at the same rate.
Second, be aware that the two most common regimes are the progressive and light capital gains tax regimes.
Finally, the key takeaway for us as portfolio managers is to understand is that different investment strategies might be more optimal depending on the tax regime our clients are in. For example, you would buy fewer dividend stocks under the heavy dividend tax regime.
For the CFA Level 3 exam be prepared for a question worth a few points on tax regimes. The good news is that it should be easier to memorize given that the names indicate, at least for the most part, how they treat each given tax.