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Difficulty: MediumTypes and Systems of Taxation

An ad valorem consumption tax is levied at a flat rate of 10%10\% on all retail purchases. A low-income household earning N100,000\text{N}100,000 monthly spends N60,000\text{N}60,000 on taxable goods, while a high-income household earning N500,000\text{N}500,000 monthly spends N150,000\text{N}150,000 on taxable goods. Based on the effective tax rate relative to total income, which system of taxation does this tax illustrate?

  1. A regressive tax system, because the effective tax rate decreases as income risesAnswer
  2. B
    A progressive tax system, because the absolute amount of tax paid increases with higher income
  3. C
    A proportional tax system, because a uniform tax rate of 10%10\% is charged on all purchases
  4. D
    A direct tax system, because the tax is assessed directly on household expenditure

Answer

A regressive tax system, because the effective tax rate decreases as income rises
The correct answer is that the scenario illustrates a regressive tax system because the effective tax rate relative to total income falls as income increases. The low-income earner pays 6%6\% of total income in tax (N6,000\text{N}6,000 out of N100,000\text{N}100,000), while the high-income earner pays 3%3\% of total income (N15,000\text{N}15,000 out of N500,000\text{N}500,000).

Step-by-Step Solution

1
Calculate the amount of tax paid by each household
Low-income household tax = 10% of N60,000=N6,00010\% \text{ of } \text{N}60,000 = \text{N}6,000. High-income household tax = 10% of N150,000=N15,00010\% \text{ of } \text{N}150,000 = \text{N}15,000.
Tax paid is computed by applying the 10%10\% rate to taxable consumption expenditure.
2
Compute the effective tax rate (tax paid as a percentage of total income) for both households
Low-income effective rate = N6,000N100,000×100=6%\frac{\text{N}6,000}{\text{N}100,000} \times 100 = 6\%. High-income effective rate = N15,000N500,000×100=3%\frac{\text{N}15,000}{\text{N}500,000} \times 100 = 3\%.
System classification requires analyzing the tax burden as a proportion of overall income.
3
Determine the system of taxation based on the change in effective rate relative to income
As income increases from N100,000\text{N}100,000 to N500,000\text{N}500,000, the effective tax rate falls from 6%6\% to 3%3\%, defining a regressive tax system.
By definition, a tax system where higher income earners pay a smaller fraction of their income in tax is regressive.

Key Concept

Regressive Taxation and Indirect Tax Incidence
Estimated Time:1m 30s
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Topics

Types and Systems of Taxation

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