# Question

Suppose that the government introduces a tax on interest earnings. That is, borrowers face a real interest rate of r before and after the tax is introduced, but lenders receive an interest rate of (1 – x)r on their savings, where x is the tax rate. Therefore, we are looking at the effects of having x increase from zero to some value greater than zero, with r assumed to remain constant.

(a) Show the effects of the increase in the tax rate on a consumer's lifetime budget constraint.

(b) How does the increase in the tax rate affect the optimal choice of consumption (in the current and future periods) and saving for the consumer? Show how income and substitution effects matter for your answer, and show how it matters whether the consumer is initially a borrower or a lender.

(a) Show the effects of the increase in the tax rate on a consumer's lifetime budget constraint.

(b) How does the increase in the tax rate affect the optimal choice of consumption (in the current and future periods) and saving for the consumer? Show how income and substitution effects matter for your answer, and show how it matters whether the consumer is initially a borrower or a lender.

## Answer to relevant Questions

A consumer receives income y in the current period, income y' in the future period, and pays taxes of t and t' in the current and future periods, respectively. The consumer can borrow and lend at the real interest rate r. ...In the example laid out in the subsection titled “Ricardian Equivalance: An Example,” suppose thatb < Ny' – G' / Ny – G.(a) Solve for the equilibrium real interest rate, and the consumption of lenders and borrowers ...In the example (“Limited Commitment and Market Interest Rates”), suppose that t < (v – y')y/y'. Also suppose that t falls. What effect will this have on the market real interest rate, and on consumption? Explain.Suppose that we modify the model of the firm's investment behavior by assuming that any capital the firm has remaining at the end of the period can be sold at the price p'K (in our model we assumed the capital could be sold ...A war breaks out that is widely expected to last only one year. Show how the effect of this shock on aggregate output depends on the size of the intertemporal substitution effect of the real interest rate on current leisure, ...Post your question

0