In: Economics
Given a nominal interest rate of 6 percent, in which of the following cases would you earn the lowest after tax real rate of interest? a) inflation is 4 percent, the tax rate is 5 percent.
b) inflation is 3 percent , the tax rate is 20 percent. c) inflation is 2 percent, the tax rate is 30 percent. d) The after tax real interest rate is the same for all of the above.
ANSWER:
Nominal interest rate = 6%
a) inflation is 4 percent, the tax rate is 5 percent.
Reduced nominal interest rate = nominal interest rate * tax rate = 6% * 5% = 0.3%
After tax nominal rate = nominal interest rate - Reduced nominal interest rate = 6% - 0.3% = 5.7%
the after tax real interest rate = After tax nominal rate - inflation rate = 5.7% - 4% = 1.7%
b) inflation is 3 percent , the tax rate is 20 percent.
Reduced nominal interest rate = nominal interest rate * tax rate = 6% * 20% = 1.2%
After tax nominal rate = nominal interest rate - Reduced nominal interest rate = 6% - 1.2% = 4.8%
the after tax real interest rate = After tax nominal rate - inflation rate = 4.8% - 3% = 1.8%
c) inflation is 2 percent, the tax rate is 30 percent.
Reduced nominal interest rate = nominal interest rate * tax rate = 6% * 30% = 1.8%
After tax nominal rate = nominal interest rate - Reduced nominal interest rate = 6% - 1.8% = 4.2%
the after tax real interest rate = After tax nominal rate - inflation rate = 4.2% - 2% = 2.2%
So, the lowest that i would earn is option c that is when inflation is 2 percent, the tax rate is 30 percent. as it has the highest real interest rate.