Financial Update (Third Quarter 2003)



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TIPS: Are They Really ?Tax Disadvantaged??

TIPS

In 1997 the U.S. Treasury introduced TIPS — inflation-protected (or indexed) securities — with much promotional fanfare. Despite the Treasury’s educational and promotional efforts aimed at TIPS, and TIPS? well-established benefit as an inflation hedge, many finance professionals question the appeal of TIPS to a wide audience. Some advisers, in fact, recommend holding TIPS only in tax-deferred accounts.

One reason to question whether there is a broad demand for TIPS is the somewhat unique tax treatment placed on them. Taxes must be paid annually on any accrued increase in principal caused by inflation, even when this gain is unrealized. Because of this treatment, several leading authorities in the field characterize TIPS as “tax disadvantaged.”

An Atlanta Fed working paper by Scott E. Hein and Jeffrey M. Mercer reconsiders this notion. The analysis suggests that TIPS are no more tax disadvantaged than conventional Treasury debt. The authors argue that the annual taxation of the accretion of principal is necessary to make the overall taxation of TIPS comparable to conventional Treasury securities in an inflationary environment.

Hein and Mercer also show empirically that, consistent with their argument, a sizable proportion of outstanding TIPS have higher expected after-tax yields than their conventional Treasury counterparts.

An important implication of the study is that, contrary to common belief and guidance, TIPS should appeal to a larger audience than tax-exempt investors only.

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