12. Inflation-induced tax distortions

Kevin receives a portion of his income from his holdings of interest-bearing U.S. government bonds. The bonds offer a real interest rate of 3% per year. The nominal interest rate on the bonds adjusts automatically to account for the inflation rate.

The government taxes nominal interest income at a rate of 10%. The following table shows two scenarios: a low-inflation scenario and a high-inflation scenario.

Given the real interest rate of 3% per year, find the nominal interest rate on Kevin's bonds, the after-tax nominal interest rate, and the after-tax real interest rate under each inflation scenario.

Inflation Rate	Real Interest Rate	Nominal Interest Rate	After-Tax Nominal Interest Rate	After-Tax Real Interest Rate
(Percent)	(Percent)	(Percent)	(Percent)	(Percent)
2.0	3.0
6.5	3.0

Compared with higher inflation rates, a lower inflation rate will the after-tax real interest rate when the government taxes nominal interest income. This tends to saving, thereby the quantity of investment in the economy and the economy's long-run growth rate.