Inflation's Distorting Effects on Taxation of Interest

We've been in the era of 2% inflation so long that many of the distortions it causes have faded from memory. While reading up on iBonds, I remembered one of them: taxes are assessed against total returns, not real returns.

High-inflation example: 

• Inflation is 8%
• Your aggregate marginal tax rate is 32%
• You earn 10% interest (2 points above inflation)

So your after-tax yield is 6.8%--somewhat below inflation, so you are not even quite preserving your capital.

Low-inflation example:

• Inflation is 2%
• Same aggregate marginal tax rate of 32%
• You earn 4% (2 points above inflation)

Your after-tax yield 2.76%--somewhat above inflation.