Question

The nominal interest rate is 4%, the inflation rate is 1% and the tax rate is 20%. Given U.S. tax laws, how is after-tax real return computed?

Select one:
a. .03(1-.20)
b. .04(1 -.20)
c. .04(1 - .20) - .01
d. None of the above is correct.

Answer 1

The after-tax real return is found by adjusting the nominal interest rate for taxes and inflation. The correct calculation method is 0.04(1 - .20) - .01, making the correct answer c. This reflects the impact of a 20% tax rate and a 1% inflation rate on a 4% nominal interest rate.

Step-by-step explanation:

The after-tax real return is computed by adjusting the nominal interest rate for taxes and inflation. First, you calculate the after-tax nominal interest rate by subtracting the tax liability (the tax rate times the nominal interest rate) from the nominal interest rate. Then, you adjust this after-tax nominal rate for inflation to get the after-tax real interest rate.

To calculate this based on the given rates: nominal interest rate (4%), inflation rate (1%), and tax rate (20%), the computation is as follows: You start with the nominal interest rate (0.04) and adjust for the tax rate, which gives you 0.04(1 - 0.20).

The result is the after-tax nominal interest rate. From this, you subtract the inflation rate to get the after-tax real interest rate, which is 0.04(1 - 0.20) - 0.01.

Therefore, the correct answer to compute the after-tax real return given the U.S. tax laws is c. 0.04(1 - .20) - .01.