Question

Ruth has a 25% marginal tax rate and she invested $350,000 in a City of Carthage bond that pays 5% interest. Alternatively, Ruth could have invested the $350,000 in a corporate bond that pays 9% interest with similar risk and other non-tax characteristics. What is Ruth’s explicit tax on the City of Carthage bond?

Answer 1

Ruth will incur $0 explicit tax on the City of Carthage bond as the interest income is tax exempt.

Step-by-step explanation:

a) Data and Calculations:

Ruth's investment in the City of Carthage = $350,000

City bond's rate of interest = 5%

Total interest income from the City's bond = $17,500 ($350,000 * 5%)

Tax payable on the interest income from the City's bond = $0.

Ruth's investment in the corporate bond = $350,000

Corporate bond's interest rate = 9%

Total interest income from the corporate bond = $31,500 ($350,000 * 9%)

Tax payable on the interest income from the corporate bond = $7,875 ($31,500 * 25%).

Net income realized after tax = $23,625 ($31,500 - $7,875)

b) However, based on the comparison of the two interest income streams, Ruth can be said to be paying an implicit tax worth $6,125 ($23,625 - $17,500), which is the lost income she incurs by investing in the tax-exempt City of Carthage bond instead of investing in the corporate bond.