9. Inflation-induced tax distortions Gilberto receives a portion of his income f

Question

9. Inflation-induced tax distortions Gilberto receives a portion of his income from his holdings of interest-bearing U.S. government bonds. The bonds offer a real interest rate of 4.5% 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 10%. The following table shows two scenarios: a low-inflation scenario and a high- inflation scenario. Given the real interest rate of 4.5% per year, find the nominal interest rate on Gilberto's bonds, the after-tax nominal interest rate, and the after-tax real interest rate under each inflation scenario. Inflation Rate Real Interest Rate Nominal Interest Rate After-Tax Nominal Interest Rate After-Tax Real Interest Rate (Percent) 4.5 4.5 (Percent) (Percent) 2.0 9.5 (Percent) (Percent) the after-tax real interest rate when the government taxes the quantity of investment in the economy and Compared with lower inflation rates, a higher inflation rate will nominal interest income. This tends to saving, thereby the economy's long-run growth rate.

Explanation / Answer

(1 + real rate)(1+inflation rate) = (1+nominal rate)

After tax nominal rate = Nominal rate (100-Tax tate)

Inflation rate Real Interest rate Computation Nominal interest rate After tax nominal After tax real 2% 4.5% (1.02*1.045)-1 6.59% 5.931% 4.05% 9.5% 4.5% (1.095*1.045)-1 14.43% 12.987% 4.05%

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