M & B 4th Edition by Dean Croushore

Exercise 11

Hans lives in a country that taxes only real interest income. When Hans calculates his taxes at the end of the year, he writes down on a form how much he invested and multiplies that amount times the infl ation rate for the year to arrive at his "infl ation compensation amount." Hans subtracts the infl ation compensation amount from his interest income to fi nd his taxable interest income.
a In 2011, Hans invested C 40,000 and earned C 2,000 in interest income, where C stands for "credits," which is the monetary unit of the country in which Hans lives. If the infl ation rate in 2011 was 4 percent and Hans pays taxes equal to 25 percent of his income, how much will Hans pay in income tax on his interest income? What is Hans's before-tax realized real interest rate? His after-tax realized real interest rate?
b In 2012, Hans invested C 50,000 and earned C 5,000 in interest income. If the infl ation rate in 2012 was 6 percent (and Hans still has a tax rate of 25 percent), how much will Hans pay in income tax on his interest income? What is Hans's before-tax realized real interest rate? His after-tax realized real interest rate?
c Suppose that Hans had to pay taxes on his nominal interest income instead of his real interest income. Repeat the analysis in parts a and b under this assumption. Does it make much difference if taxes are based on nominal income instead of real income?