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Economic Review

Jul/Aug, 1984

The Tax Effect, and the Recent Behaviors of the After-Tax Real Rate: Is It Too High?

Yash P. Mehra

Concerns that interest rates are too high have been prevalent throughout the 1980s. Even after adjusting for expected inflation, many people argue that real interest rates are inordinately high by historical standards. Yash Mehra, in his article "The Tax Effect and the Recent Behaviour of the After-Tax Real Rate: Is It Too High?", points out that because interest income is taxed, business decisions are based on the after-tax real rate and public concern should focus on this measure of interest rates.

Mehra adds to the accumulating evidence that changes in taxes on interest income alter the nominal interest rate. He suggests that unusual interest rates occurred in the 1970s, when the after-tax real rate was negative because of rising inflation and shocks to the supply side of the economy, such as oil price increases. Today's real interest rate may appear high relative to the negative levels observed in the '70s; however, after-tax real short-term rates in the 1980s have not been significantly higher than they were in the '50s and '60s.

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