that may not be relevant to an investor who today faces a 38.6 percent federal tax rate. However, calculating historic after-tax returns using today's tax rates ignores the interplay between tax rates and the relative demand for stocks and bonds. Past returns would likely have been different if today's tax rates were in place. Another complicating variable is the long-term trend toward lower dividend yields. Dividends are currently taxed as ordinary income, while appreciation is taxed at the lower capital gains rate. Thus, a greater portion of past stock returns were subject to ordinary taxation than is likely to be the case going forward. This requires some sort of simple, subjective compromise. 11 Government bond and Treasury bill returns will be subject to a 30 percent tax rate. This is reasonable because municipal bonds often trade at yields about 70 percent of comparable maturity government bonds. A high-bracket taxable investor is likely to buy a municipal bond rather than a government bond subject to about 40 percent tax. 11 Stock returns consist of dividends and appreciation. Dividends are currently taxed as ordinary income, while appreciation is usually taxed at long-term rates when the security is sold. In the previous chapter we demonstrated that deferral of capital gains taxes over long periods can meaningfully reduce the effective tax rate. Ordinary tax rates have fluctuated a great deal over the past 76 years, and so has the portion of stock returns from dividends. Our assumption is that investors hold broadly diversified stock portfolios that have returns in line with the overall market. We will further assume that these investors are sensitive to taxes and thus favor long holding periods. We will subject stock returns to 20 percent tax in our analysis. Any attempt to convert historic returns to an after-tax basis requires some arbitrary assumptions. This approach seems reasonable. There is no point in being overly precise because, as demonstrated in the preceding chapter, the actual taxation of an asset depends on the factors of timing, disposal, and entity. This exercise is intended only to give us a rough idea of how taxes may alter expected returns and change relative risk/return ratios of different asset classes. Taxes are applied to nominal returns, not real returns. If a bond yields 6 percent, the investor owes tax on the 6 percent yield even if inflation is consuming one-half or more of the nominal return. The combined impact can be seen in the adjusted data shown in Table 30.3. TABLE 30.3 Combined Impact Nominal Real Real After-Tax Stocks 10.68% 7.41% 5.57% Bonds 5.33 2.21 0.66 Cash 3.81 0.73 -0.39 Source: Ibbotson Associates.