Consider a two period intertemporal choice problem. Anne earns an income of R400,000 in period 1. The interest rate available is 5% and there is a 40% tax on saving. A retirement tax subsidy is introduced. Individuals can contribute to a retirement fund in period 1. After accounting for the retirement tax subsidy, the share of tax that remains is 50% smaller.

1. Draw a graph with consumption in period 1 on the x-axis and consumption in period 2 on the y-axis to illustrate Anne's optimal choice of consumption and saving without the retirement subsidy. Then indicate the effect of the subsidy on the intertemporal budget constraint.
2. After the introduction of the retirement tax subsidy, we find that Anne's savings decrease. Use a graph to explain whether the income effect or the substitution effect dominates.

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Intertemporal Choice with Retirement Tax Subsidy 1 Optimal Choice without Subsidy Graph The xaxis represents consumption in period 1 C1 The yaxis repr... View the full answer