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Suppose the current market rate of interest is 22 percent. Ayse is subject to a 40 percent marginal tax rate on her interest income. What is Ayses equilibrium marginal rate of time preference? Suppose the marginal tax rate John is subject to decreases to 30 percent. Can you predict the effect of the decrease in marginal tax rates on Ayses current saving?

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Answer #1

Equilibrium marginal rate of time preference will be at the point where the net utility derived from the savings is equal to the dis-utility generated by not consuming that amount. Therefore,

Utility derived from the savings = 0.22Y - 0.4(0.22Y) = 0.22Y - 0.088Y = 0.132Y.

Therefore, equilibrium marginal rate of time preference is 0.132 or 13.2%.

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When the tax rate decreases, the return on savings increases. When the savings increase, utility from sacrificing present consumption increases. Therefore, Ayse's net return will be 15.4% (=0.7 multiplied by 0.22 = 0.154 or 15.4%).

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