Mallovia has two tax brackets. The first $20,000 in income is taxed at a 10% marginal rate, and income above $20,000 is taxed at a 30% marginal rate. All income-earned income and nominal interest, dividend, and capital-gains income-is treated the same. The threshold for the 30% rate is currently indexed for inflation, and the real interest rate is 5%.
a. How does inflation affect the returns to saving in Mallovia? Compare the likely savings rate when expected inflation is 10% with the likely savings rate when expected inflation is zero.
b. How would your answer change if the threshold for the 30% rate were not indexed for inflation?