Question

Ms V resides in a jurisdiction with a 35% income tax. Ms V has $40,000 that she could invest in bonds paying 8% annual interest. She is also considering spending the $40,000 on a new luxury auto. Ms V has a tough time deciding. Why might it become easier if the jurisdiction increases its income tax rate to 50%?

Answer 1

Answer:

Increase in tax rate will reduce income form bond but will not affect the benefits derivable from the purchase of the new luxury auto.

Explanation:

First, a look at the after tax rates for when tax is 35% and when it is increased to 50%.

Step 1: Compute the after tax rate when tax is 35%

=Interest rate x (1-tax rate)

= 0.08 x (1- 0.35)

-5.2%

Step 2: Compute the after tax rate when tax is increased to 50%

= Interest rate x (1- tax rate)

= 0.08 x (1-0.5)

=4%

The first outcome is that an increase in tax rate leads to a decrease in income. Meaning an increased tax rate reduces the income from the bonds.

However, an increase in tax rate although it will affect the income will have no effect on the new luxury condo, that Ms V wants to buy. This is because, the benefits Ms V will get from the auto cannot be taxed as compared with the interest on the bond.

Hence, it becomes easier for Ms V to buy the luxury auto than invest in bonds if the tax rate should increase