Suppose a person lives for two periods (working life and retirement) earning $30,000 in income in his working life, during which he consumes or saves for period a. What is saved earns interest of 10% per year.
a. Draw this person’s intertemporal budget constraint.
b. On the same graph, draw this person’s intertemporal budget constraint if the government taxes interest at 30%.
c. Suppose the government increases the tax rate on interest earned and this person saves more. What effect dominates, the income or substitution effect? Explain.
d. Suppose the government increases the tax rate on interest earned and this person does not change his amount saved. What other motivations could be influencing his saving decision?
e. Continue the situation in part (b) above. Now suppose the government offers a tax-deferred saving program for the first $5,000 of income saved. Sketch the new intertemporal budget constraint on a new graph. If this person has saved $2,000 in the past, do you think this program will increase his net saving? Why or why not?