How does the corporate income tax influence investment and saving and the real interest rate? Draw...

How does the corporate income tax influence investment and saving and the real interest rate? Draw a graph to illustrate your answer.

Expert Solution

The relation between corporate income tax and investment demand is inversely related. If corporate taxes increases, then the returns from investments are reduced by the amout of taxation. Hence a increase in corporate tax will decrease investment demand and vice versa.

Consider the market for lonable funds. The investment function is downwards sloping i.e investment increases as interest rate falls. While savings function is upward sloping i.e higher interest rates attract savings. Now lets consider an increase in corporate taxes which shifts investment demand curve downward from I1 to I2. This causes the real interest rate to fall from r1 to r2. This leads to a fall in equilibrium amount of savings and investment. Savings decreases along the saving curve as real interest rate falls.

Hence we can conclude that corporate taxes discourage investment and savings, decreases real interest rates.

Rahul Sunny answered 8 months ago

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