Inflation and taxes on asset income Suppose that the tax rate on asset income is
ID: 2753162 • Letter: I
Question
Inflation and taxes on asset income
Suppose that the tax rate on asset income is Tc and tax is leived on nominal interest income. Assume that the tax applies to the real returns on capital.
a. what is the after tax real interest rate on bonds? consider permanet, unanticipated increase in the money growth rate from u' to u, assume that tax of income does not change
b. what is the effect on the inflation rate?
what is the effect on after tax real return on capital
what is the effect on the after tax real interest rate on bonds? what happends to the nominal interest rate? does it move one for one with income
Explanation / Answer
a. If tax rate = Tc
After tax interest rate of bond = Interest (1-Tc)
b. Inflation rate will significantly increase with respect to increased money growth rate.
After-tax real return will be decreased.
Bond interest rate have inverse relationship with bond prices. hence after tax interest rate on bonds will be lower.