Consider the two period intertemporal consumption model that we
discussed in class. Suppose that Mike earns $30,000 from working in
period 1. In period 2, he retires and earns nothing. What is saved
in period 1 earns interest of 10%. Suppose now that the government
taxes interest income at the rate of 30%.
(a.) Write down the intertemporal budget constraint as a function
of C1 (first-period consumption) and C2 (second-period
consumption). Draw the intertemporal budget constraint (put C1 on
the horizontal axis) and mark the intercepts.
(b.) Suppose that after the government taxed interest income, Mike
increased his savings. Write down and draw the new intertemporal
(c.) What is the substitution effect of this tax on first-period
consumption and on savings? What is the income effect?
(d.) If the substitution effect is larger than the income
effect, will Mike save more or less after tax on interest is
imposed? Graphically depict how the optimal point moves.
Thank you for help!