Inflation-induced tax distortions Raphael receives a portion of his income from
ID: 1228348 • Letter: I
Question
Inflation-induced tax distortions Raphael receives a portion of his income from his holdings of interest-bearing U.S. government bonds. The bonds offer a real interest rate of 4% per year. The nominal interest rate on the bonds adjusts automatically to account for the inflation rate. The government taxes nominal interest income at a rate of 20%. The following table shows two scenarios: a low-inflation scenario and a high-inflation scenario. Give the real interest rate of 4% per year, find the nominal interest rate on Raphael's bonds, the after-tax nominal interest rate, and the after-tax real interest rate under each inflation scenario. Compared with higher inflation rates, a lower inflation rate will the after-tax real interest rate when the government taxes nominal interest income. This tends to saving, thereby the quantity of investment in the economy and the economy's long-run growth rate.Explanation / Answer
Real interest rate + Inflation rate = nominal interest rate
Nominal interest rate - 20% = After tax nominal interest rate
After tax nominal interest rate- Inflation rate = After-tax real interest rates
1) 5.5 4.4 2.9
2) 12 9.6 1.6
Increase
Increase
increasing
increasing.