A 64-year-old man asks:

It does feel strange to be charged tax on no real return. But that’s how our tax system works in Iceland.

From time to time, there has been discussion about changing the tax base for capital income tax so that only real returns are taxed. For some reason, there seems to have been little interest in actually making that change, or at least little success in getting it done.

The difference between real and nominal returns

The interest paid on bank accounts, as well as the indexation (also known as inflation compensation) added to indexed accounts, is called the nominal return. For example, if a non-indexed account pays 7% interest over a year, its nominal return is also 7% for that year.

If an indexed account pays 1.7% interest and inflation is 5.2% over the same period, the nominal return is also just under 7%.

That is calculated like this:

(1 + 0.017) x (1 + 0.052) - 1

Capital income tax is paid on the nominal return

If your grandchildren save for a home in an indexed bank account, the current Icelandic 22% capital income tax will be deducted from the full nominal return, as you point out.

Let’s say they have ISK 10 million in the indexed account mentioned above. Their return for the year would be:

ISK 10,000,000 x 0.0699 = ISK 699,000

But inflation has reduced the purchasing power of the money by 5.2%. The real return is only the 1.7% real interest on the account, or ISK 170,000.

Capital income tax, however, is deducted from the nominal return:

ISK 699,000 x 22% = ISK 153,780

The tax therefore equals about 90% of the real return. We should not forget the tax-free allowance for capital income, which can be deducted from returns on bank deposits, among other things. The allowance is ISK 300,000 per individual per year, and the tax paid on that amount is refunded the following year. Taking the allowance into account, the tax is lower, although still very high:

(ISK 699,000 - ISK 300,000) x 22% = ISK 87,780

In the end, the tax equals about 52% of the real return on the savings.

If the same nominal return had been earned on a non-indexed bank account, the effect would have been the same. So, in this particular respect, indexed accounts are not treated worse than non-indexed accounts.

This is worth remembering when saving and investing. High taxes matter. So do any costs connected with earning a return on your money.

Returns can become strongly negative because of benefit reductions

The effect can be even greater when the saver also receives payments from the Icelandic social security system. In that case, capital income tax is paid on the nominal return, and social security payments may also be reduced because of the nominal return. It is therefore not uncommon for taxes and benefit reductions to exceed the real return on the money.

That does not mean, of course, that people should keep their savings under the mattress. Inflation will set fire to the pile of banknotes there just as surely as it eats into the bank account.

So what should your grandchildren do?

These are the rules today, and there is little to suggest that capital income tax will be reduced soon. In fact, capital income tax on rental income was increased by half at the beginning of the year, and we hear more talk about further tax increases than tax cuts.

Still, encourage your grandchildren not to give up just because the system makes things harder.

Hopefully, they can at least maintain the real value of the money they save. On top of that, they may be able to use their supplementary pension savings tax-free when buying their first home.

This article first appeared on Vísir.