Question

You buy a one-year debt security on December 31, 2016, for $10,000, which will pay you a nominal interest rate of 5%. From December 31, 2016, to December 31, 2017, the inflation rate is 2%. You have a tax rate of 35%. Answer the following and show your calculations.

e) How much real interest income do you earn?

f) How much is your after-tax real interest income?

g) What percent of your nominal interest income goes to:

(1) you, in the form of after-tax real interest income

(2) the government, in the form of taxes

(3) inflation, in the form of lost principal value

Answer 1

e:

Real interest income before tax = 5%*10000*(1-0.02)

= $490

f:

Real interest income after tax = 490*(1-0.35)

= 318.50

g:

Nominal income = (5%*10000)= 500

Percent of your nominal interest income that goes to:

(1) you, in the form of after-tax real interest income = After tax real income/ Nominal Income

= 318.5/500

= 63.7%

(2) the government, in the form of taxes

Tax = 35%*490 = 171.5/500

= 34.30%

(3) inflation, in the form of lost principal value

= (500-490)/ 500

= 2%