Suppose that the only tax levied in the economy is a business income tax at a rate of 50%. The government is planning to finance a public project by selling $10 million worth of bonds to the public. It is estimated that the bond sale will displace $6 million worth of private consumption expenditure, and $4 million worth of private investment. The market rate of interest (after tax) is 4% and all private investment projects are perpetuities.
(i) What is the before-tax rate of return on private investment?
(ii) What is the present value, at the market rate of interest, of the before-tax return on $1 worth of private investment?
(iii) What is the opportunity cost to the economy of the reduction in private consumption and investment resulting from the bond sale?
(iv) What is the marginal cost of public funds (per dollar of public funds raised) obtained by borrowing from the public?