THE TAXATION OF TREASURY INFLATION PROTECTED SECURITIES: ARE THEY TAX-DISADVANTAGED?

• Date: 22 September 2022
• Author: Morgan, Robin

INTRODUCTION 2
                I. A BRIEF OVERVIEW OF TIPS 6
                II. [section] 1.1275-7 AND THE TAXATION OF TIPS 8
                A. TIPS Acquired at Par 9
                B. TIPS Acquired at a Premium 10
                C. TIPS Issued at a Discount (OID) 11
                D. TIPS Purchased on Secondary Markets at a
                Discount (Market Discount) 12
                E. Gaming the Rules: Tax Trading and TIPS 13
                III. AFTER-TAX TIPS RETURNS AND THE CPI-U BETWEEN
                2003 AND 2022 15
                IV. COMPARING PAYOFFS FROM TIPS, NOMINAL TREASURY
                Bonds and I Bonds: Are TIPS Tax-Disadvantaged? 19
                A. Growth of $100: Results for 2003-2021 21
                B. Growth of $100: Results for 2003-2022 23
                C. Effective Tax Rates of TIPS, Nominal Treasuries
                and I Bonds 24
                V. CONCLUSION 28
                

INTRODUCTION

With inflation making headlines against the backdrop of a global pandemic and record government spending, market participants are trying to determine how best to hedge against a depreciating dollar. (1) For investors looking for a riskless investment safe from inflation, Treasury Insurance-Protected Securities (TIPS) look like a great deal. TIPS are special since any interest and principal repayments are indexed for inflation according to the urban consumer pricing index (CPI-U), meaning that the bonds provide real rather than nominal returns. This can be quite desirable since investors can lock in real yields and protect against inflationary shocks. For example, if annualized inflation is 10%, a TIPS bond with stated 5% interest would see its basis rise by 10% such that the 5% interest would be paid out according to this new adjusted basis. A nominal bond with 5% stated interest is based on nominal principal, such that there is no inflation adjustment and hence inflation erodes the value of future cash flows. Under normal circumstances markets should factor expected inflation into the pricing of both nominal Treasuries and TIPS, such that they have equivalent ex-ante real yields. Should unanticipated inflation exceed expected inflation, then TIPS will have been the better investment on an ex-post basis. Should unanticipated inflation have been below expected inflation, then TIPS will have performed worse than nominal Treasuries on an ex-post basis. In this way, TIPS hedge against unexpected inflation.

The tax treatment of inflation-indexed securities renders the ex-ante equivalence between nominal Treasuries and TIPS more complicated. Under Regulations section 1.1275-7, a taxpayer's basis in an inflation-indexed security (like TIPS) is adjusted annually to reflect inflation, with any such adjustment includable as original issue discount (OID). For a bond issued at par, the unsuspecting taxpayer would soon find that TIPS are not protected against inflation on an after-tax basis. This is why most TIPS are held by tax-exempt entities like pension funds, and why TIPS have been referred to as tax-disadvantaged Treasuries. (2) Empirical work has similarly found that the marginal investor for nominal Treasuries is tax exempt as well; hence taxes are not built into the pricing of either nominals or TIPS. (3)

Amidst relatively low inflation at the start of the 21st century the tax implications of TIPS have received limited academic attention. A brief literature exists mentioning the tax disadvantaged status of inflation-indexed bonds and arguing that taxpayers should not hold TIPS since after-tax yields may fall below the inflation rate. (4) Moreover, the great majority of TIPS-related scholarship estimates and discusses the inflation-related informational content of the instruments. (5) Both of these are valid points. However, our understanding of the tax implications of TIPS on financial flows is limited, and what does exist focuses on a dimension which shifts the analysis away from the average (taxable) investor. What may be a far more realistic and relevant comparison for the individual investor is how TIPS perform relative to nominal Treasuries. Therefore, in addition to comparisons to inflation, the main focus of this article is to determine what riskless securities the individual investor should be investing in to maximize after-tax returns.

Given the resurgence of inflation in the public consciousness following Covid-19, it is an opportune time to engage in an in-depth analysis of TIPS' tax characteristics. Building on work by Scott Hein and Jeffrey Mercer, I ask whether the common wisdom that TIPS should not be held by taxable investors is correct. (6) To test this hypothesis I compare the effective tax rates of TIPS to both nominal Treasuries and I Series Savings Bonds (I Bonds) over the 2003-22 period to see if TIPS are as tax-disfavoured as many assume. (7) I find that the tax-disadvantaged status of TIPS is true in the simple, mechanical sense that a tax on inflation will generate after-tax payoffs below inflation. However, I find that TIPS are not tax-disadvantaged relative to nominal Treasuries, and in fact find that under certain conditions (like withholding of interest) TIPS are tax-favored. (8)

This Article likewise examines the after-tax performance of 10-year TIPS compared to nominal Treasuries and I Bonds with similar maturities. Since we expect to see a divergence in performance based on unanticipated inflation, I perform the same analysis on two similar data sets. First, I study the January 2003 to January 2021 period. Second, I study the January 2003 to January 2022 period. The only difference is the inclusion of data from 2021 in the second set, which is a unique year across the period due to substantial unexpected inflation brought on by the consequences of and responses to COVID-19. Comparing the two allows for the assessment of the impact of unanticipated inflation on the after-tax performance of TIPS. I find that for the first data set, the 2003-21 period, nominal Treasuries outperform both TIPS and I Bonds. However, for the 2003-22 period, TIPS outperform both nominal Treasuries and I Bonds. This result confirms theory, since TIPS are expected to be good hedges against unexpected inflation, and reinforces the heavily period-dependent nature of financial study. Future work studying the performance of TIPS across the 2020s is necessary for exactly this reason, and will likely find a much more striking differential between TIPS and nominal Treasuries. A final finding is that no riskless asset--whether TIPS, nominal Treasuries or I Bonds--outperformed inflation between 2012 and 2022 on an after-tax basis. Thus, taxpayers did not have access to a positive real riskless return for the past decade.

This Article proceeds as follows. Section I gives a quick summary and history of TIPS, paying special attention to their tax consequences. Section II outlines the mechanics of TIPS taxation under the section 1.1275-7 regime, including a discussion of how taxable investors can minimize their tax burdens. Section III determines whether after-tax TIPS returns exceeded the CPI-U for the 2003-22 period. The hand-constructed dataset and empirical findings of this section are a central contribution to the TIPS-related literature since they attempt to assess the after-tax consequences of TIPS compared to other instruments. All datasets and code are made publicly available in the online appendix. (9) Section IV continues this analysis by comparing the after-tax performance of TIPS to nominal Treasury bonds and I Bonds. My results show that inflation-indexed bonds are not tax-disadvantaged relative to nominal bonds on a buy-and-hold basis and can even be tax-favored for certain taxpayers. Section V concludes.

I. A BRIEF OVERVIEW OF TIPS

TIPS are effectively risk-free assets that have the added benefit of being protected against unanticipated inflationary risk. As mentioned above, since inflation is already priced into nominal bonds, both TIPS and nominals compensate for expected inflation. Instead, it is unexpected inflation that TIPS really protect against. Regarding their terms, TIPS are normally issued at maturities of five, 10 or 30 years and are less liquid than nominal Treasuries. TIPS pay coupons semi-annually at a fixed rate and on an inflation-adjusted principal. This inflation-indexing schedule is provided online, with each entry being a three-month-lagged CPI-U statistic, which is the Consumer Price Index for all Urban consumers (in other words, inflation as measured by the impact of consumers in urban settings), as published by the Bureau of Labor Statistics. (10) For example, April's reference is based on January's CPI-U. For tax purposes, daily intra-month adjustments are made using straight-line interpolation. (11) At maturity, a TIPS bond pays the holder either the original or an inflation-adjusted principal, whichever is greater. The principal repayment can therefore be thought of as a zero-coupon nominal bond with a stated value of the original principle, plus an inflation-based option.

TIPS are taxed on nominal rather than real terms, which may seem surprising and even counterintuitive until one considers the potential for arbitrage. The application of the nominal tax framework to TIPS is deliberate. In the 1990s Congress began to seriously consider introducing inflation-indexed bonds following their then-recent success in the United Kingdom and Canada. (12) Based on the bonds' strong showing abroad, Treasury saw two primary benefits of their introduction into American markets. First, it was thought that inflation-indexed bonds would allow Treasury to issue cheaper debt and be a net revenue raiser. (13) Second, issuing both real and nominal bonds would allow Treasury to access new economic data to determine long-term interest rates, particularly expectations as to long-term inflation and the real interest rate. (14) A third and less prevalent concern suggested by various members of Congress was that offering inflation-indexed bonds would encourage more private savings. (15)

This last point was explicitly rejected by Treasury when it recommended that TIPS be taxed on nominal instead of real terms, including taxing yearly inflation...