Problem
Suppose that the government introduces a tax on interest earnings. That is, borrowers face a real interest rate of 3' before and after the tax is introduced, but lenders receive an interest rate of (1-x r on their savings, where x is the tax rate. Therefore, we are looking at the effects of having x increase from zero to some value greater than zero, with r assumed to remain constant.
1. Show the effects of the increase in the tax rate on a consumer's lifetime budget constraint.
2. How does the increase in the tax rate affect the optimal choice of consumption [in the current and future periods) and saving for the consumer? Show how income and substitution effects matter for your answer, and show how it matters whether the consumer is initially a borrower or a lender.