Suppose Bob Considers Borrowing $100 from Sheila

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The Answer is The after-tax real interest rate can be calculated using Fischer's formula,where the nominal interest rate is the after-tax value:After-tax real interest rate = After-tax nominal interest rate minus Inflation rate.Let t be the tax rate,r the after-tax real interest rate,i the nominal interest rate,and ð the inflation rate.Fisher's formula becomes r = i(1 - t)- ð.When a target after-tax real interest rate is given,the corresponding nominal interest rate is i = (r + ð) / (1 - t).If Bob and Sheila are aware of the interest income tax and they agree on a 4 percent after-tax real interest rate,the nominal interest rate should be equal to (4% + 6%) / (1 - 0.3)= 14.28%.If they expect inflation to be 8 percent,then the corresponding nominal interest rate should be (4% + 8%) / (1 - 0.3)= 17.14%.One can notice that,because of the tax,the increase in the nominal interest rate is higher than the increase in the inflation rate.This,of course,would make Bob think twice before borrowing.Like any other tax,a capital gain tax will induce an additional burden on both lender and borrower.(Sheila may also agree to lower her after-tax real interest rate expectations in order to persuade Bob to borrow.)

Suppose Bob Considers Borrowing $100 from Sheila

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Suppose Bob Considers Borrowing $100 from Sheila

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Correct Answer:VerifiedShow Answer

Correct Answer:
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