Question

Firms care about their after-tax rate of return on investment projects. In the market for loanable funds, draw a graph and explain the effect of an increase in taxes on business profits. (For simplicity, assume no change in the federal budget deficit or budget surplus.) What happens to the equilibrium real interest rate and the quantity of loanable funds? What will be the effect on the level of investment by firms and the economy's capital stock in the future?

Short answer

The increased tax on business profits will shift the demand curve of loanable funds to the left, reducing the equilibrium quantity of loanable funds and the equilibrium real interest rate. This will lead to a decrease in investments by firms and the future capital stock of the economy.

Step-by-step solution

Draw Initial Supply-Demand Graph

Draw a graph with 'Loanable Funds' on the x-axis and 'Real Interest Rate' on the y-axis. The demand curve slopes downward while supply curve slopes upward, intersecting at the equilibrium point.

Identify Initial Equilibrium

The point where the supply and demand curves meet represents the current equilibrium of quantity of loanable funds and real interest rate. This equilibrium will change when a new tax is introduced.

Identify Tax Impact

An increase in taxes on business profits reduces after-tax profit, which discourages investments resulting in a decrease in the demand for loanable funds. The demand curve shifts to the left.

Identify New Equilibrium

The new equilibrium is now where the new demand curve intersects the supply curve. This represents the new quantity of loanable funds and real interest rate.

Discuss New Equilibrium Impact

The equilibrium real interest rate is now lower as is the quantity of loanable funds. Investment by firms will decline as a result of the tax increase, leading to a decrease in the economy's capital stock in the future.

Key concepts

After-Tax Rate of Return

Understanding the after-tax rate of return is essential for any firm managing investment projects. This rate measures the profit an investment generates after accounting for taxes, which significantly impact business decisions.

Let's consider an investment that promises a 10% return; if taxes take away 3%, the after-tax rate of return is only 7%. It is this 7% figure that a firm uses to gauge the attractiveness of the project. When taxes on business profits increase, this after-tax return diminishes. Consequently, firms might be less inclined to undertake certain investments, especially if the after-tax return falls below their threshold for what they consider a worthwhile investment.

For investors and firms alike, it's not just about the gross return, but more importantly, the net return that they get to keep after taxes. The higher the tax burden, the more it can dampen investment enthusiasm.

Real Interest Rate

The real interest rate is the nominal interest rate adjusted for inflation, providing a clearer picture of the true cost of borrowing and the real yield on investment.

From a borrower's perspective, the real interest rate informs them of the actual purchasing power they are forfeiting in the future. Conversely, from a saver's or investor's viewpoint, it reflects the actual increase in purchasing power they can expect from their saved or invested funds.

In the scenario where taxes on business profits rise, the real interest rate effectively increases for borrowers, as they must now secure a higher gross return to satisfy the same after-tax return as before. Consequently, firms demand less loanable funds at any given nominal interest rate. As investments become more costly, some marginally profitable projects may no longer be viable, reducing overall demand for loanable funds.

Investment and Taxes

Taxes can act as a significant deterrent to investment. They reduce the after-tax profits, raising the cost of investment.

When taxes on business profits go up, the cost of investment increases, making many projects less attractive. This can exert a contractionary effect on the economy, as investments drive economic growth through capital accumulation and technological progress. Reduced investment can hinder improvements in productivity and, over time, affect the wealth and employment levels within an economy.

A good way to think about this is to imagine the government taking a larger slice of your pie – naturally, you would be less motivated to bake a bigger pie if you end up with the same or even a smaller piece after taxes. Therefore, when the textbook exercise posits an increase in taxes, it's crucial to consider how this action dials down firms' motives to invest, potentially leading to a future with less capital stock for the economy.

Supply and Demand in Loanable Funds

The loanable funds market is where borrowers and lenders interact, with the real interest rate balancing the quantity supplied and demanded.

The supply side comprises savers and entities willing to lend funds, while the demand side includes firms and individuals aiming to borrow for investment. An increase in taxes on business profits affects this market by reducing demand; companies see less net return from their investments and thus seek fewer funds for investment purposes. A leftward shift in the demand curve, as shown in the exercise, indicates reduced competition for loanable funds, which puts downward pressure on the real interest rate.

This dynamic is vital to understanding macroeconomic trends and the effects of fiscal policies on private sector investment and growth. Therefore, analyzing shifts in supply and demand within the market for loanable funds allows us to predict changes in investment patterns and overall economic health.

Equilibrium in Economics

Equilibrium in economics represents a state where supply equals demand; there's no incentive for change because participants in the market are satisfied at that price and quantity.

In the loanable funds market, the intersection of the supply and demand curves determines the equilibrium real interest rate and the volume of loanable funds. The introduction of increased taxes on business profits disrupts this equilibrium. As the demand for loanable funds decreases (demand curve shifts left), a new, lower equilibrium interest rate is established at the point where the new demand curve intersects the original supply curve. This transition to a new equilibrium happens as the market self-adjusts following the tax hike.

Understanding equilibrium in economics is critical because it dictates how different variables might respond to changes in the market or policy, helping anticipate the consequences for investment, consumption, and overall economic activity.