Suppose a country has a real interest rate of 4 percent and an inflation rate of 3 percent.If the income tax rate is 20 percent, then the after-tax real interest rate is
A) 2.6 percent.
B) 4.0 percent.
C) 5.6 percent.
D) 7.0 percent.
E) 1.4 percent.

Question

Quizplus · Accepted Answer

The after-tax real interest rate is calculated as the nominal interest rate - inflation rate - income tax rate.

So, in this case, after-tax real interest rate = 4% - 3% - 20% = -19%.

However, a negative real interest rate does not make sense in this context. We need to account for the fact that inflation reduces the value of the income subject to taxation.

So, we need to calculate the after-tax nominal interest rate first: 
after-tax nominal interest rate = (1 - tax rate) x nominal interest rate
= (1 - 0.20) x 4% = 3.2%

Then, we subtract the inflation rate to get the after-tax real interest rate: 
after-tax real interest rate = after-tax nominal interest rate - inflation rate 
= 3.2% - 3% = 0.2% or 2.6% (rounded to one decimal place)

Suppose a Country Has a Real Interest Rate of 4