Question

The real interest rate is 3​ percent, the inflation rate is 2​ percent, and the tax rate on nominal interest is 25 percent. What is the true income tax rate on interest​ income? Why does inflation increase the true tax rate on interest​ income?

Answer 1

True income tax on interest income:

= Tax on interest income / Real interest rate

Tax on interest income = Tax rate * Nominal interest

= 25% * (3% real rate + 2% inflation)

= 25% * 5%

= 1.25%

True income tax:

= 1.25% / 3%

= 41.67%

Why does inflation increase the true tax rate on interest​ income?

It is because tax is computed on the nominal interest rate as shown above. Nominal rates are affected by inflation such that when inflation rises, nominal rates rise as well which would lead to taxes being higher because they are now based on a higher figure.