To maintain the level of the real interest rate, the nominal interest rate must adjust according to the Fisher equation:

At the lower inflation rate of 2.5% per year, the nominal interest rate is 5.5%, the 3% real rate plus the 2.5% inflation rate. At the higher inflation rate of 6.5% per year, the nominal interest rate is 9.5%, the 3% real rate plus the 6.5% inflation rate.

The government taxes 20% of the nominal interest paid on the bonds. When the inflation rate is 2.5% per year and the nominal interest rate is 5.5% per year, the tax reduces the nominal interest payment from 5.5% to an after-tax nominal interest payment of 5.5%−(0.2×5.5%)=4.4% per year$\mathrm{5.5\%}-\left(0.2\times \mathrm{5.5\%}\right)=\mathrm{4.4\%}\mathrm{ per year}$. At an inflation rate of 6.5% per year and a nominal interest rate of 9.5% per year, the tax reduces the nominal interest payment from 9.5% to an after-tax nominal interest payment of 9.5%−(0.2×9.5%)=7.6% per year$\mathrm{9.5\%}-\left(0.2\times \mathrm{9.5\%}\right)=\mathrm{7.6\%}\mathrm{ per year}$.

Rearranging the nominal interest rate equation, you can see that the real interest rate is the difference between the nominal interest rate and the inflation rate. The after-tax real interest rate is, therefore, the after-tax nominal interest rate minus the inflation rate. At the lower inflation rate, the after-tax real interest rate is calculated as follows:

At the higher inflation rate, the after-tax real interest rate is 7.6%−6.5%=1.1%$\mathrm{7.6\%}-\mathrm{6.5\%}=\mathrm{1.1\%}$, which is lower than the after-tax real return at the lower inflation rate.

When the government taxes nominal interest income, inflation distorts the real returns to saving. Compared with a lower rate of inflation, a higher rate of inflation leads to a lower after-tax real interest rate, which tends to discourage saving. Because the economy's level of investment depends on the pool of savings available to finance investment projects (such as acquiring new tools or machinery or building new plants or office buildings), the lower volume of saving will decrease the quantity of investment, thereby decreasing the economy's rate of physical capital accumulation and depressing the long-run economic growth rate. Thus, to the extent that the central bank cannot reduce inflation in an economy in which the government taxes nominal interest income, inflation will discourage saving, investment, and growth.