Question

Micky earns $200 this year and will earn $210 next year. The interest rate is 5 percent (r=0.05), whether Micky borrows or saves.

1. Draw his intertemporal budget constraint. Calculate and show on your diagram the horizontal intercept and the vertical intercept.
2. Suppose Micky saves $100 this year so that he can consume more next year. Show his consumption choice on your diagram. How much does he consume this year and next?
3. Now suppose the government introduces a 40 percent tax on investment income, but allows any interest payments to be tax deductible (even interest payments on consumer debt). Show the effect of taxing investment income on Micky’s budget constraint.
4. Now try to draw a more realistic scenario: if Micky borrows money on his credit card, he pays an interest rate of 20 percent, and interest payments are not tax deductible. Micky pays no tax on his interest income for the first $40 he saves. Only for savings above $40 does he start to pay tax at 40 percent. Show his new budget constraint.

Answer 1

This question is about the inter-temporal choices that an individual has to make.

(a) Given here that Micky earns 200 this year and with a 5% interest rate in one year this money is also equal to 210. Hence an individual will indifference between the choices as the second bundle which gives 210 next year is equal to the money earned.

C. As tax is introduced on the investment income. Hence saving will be costly.

Hence he will try to consume the maximum in the present day only which 200.

but as given that interest payment are tax deductable he will be compensated and will reach the same inter-temporal choice

d. As no deduction is allowed on credit card he will be worse-off on taking up the loan at 20%.

On 40 he has not taxed but after 40 he is liable to pay tax. Hence till 40, he will be indifferent but the 2 bundles but as soon he gets to pay the tax he will start to consume in the present day only.