Fiscal, Monetary and Supply-Side Policy: Question 6

Worked solution

Step 1: Work out the average rate paid by each household

The average rate of tax (ART) is the tax paid divided by income. Both households pay the same $300 charge, but their incomes differ.

$ART_{Chen} = \frac{300}{15000}\times100 = 2\%$

$ART_{Osei} = \frac{300}{60000}\times100 = 0.5\%$

Step 2: Compare the average rates

The Chen household, on the lower income of $15,000, pays an average rate of $2\%$, while the Osei household, on the higher income of $60,000, pays a much lower average rate of $0.5\%$. Because the average rate falls as income rises, this charge is a regressive tax: it takes a proportionately larger bite out of a lower income than out of a higher income, even though every household pays the identical dollar amount.

Step 3: Rule out the other options

• Option A is wrong because the average rate does not stay constant. It falls from $2\%$ to $0.5\%$, so the charge is not proportional.
• Option B is wrong because the average rate falls, not rises, as income rises.
• Option D correctly notes that the average rate falls, but mislabels a falling average rate as “progressive”. A progressive tax is defined by a rising average rate.

Final answer

Option C. The average rate falls as income rises, so it is a regressive tax. A fixed charge that is the same in dollar terms for every household, regardless of income, is a textbook example of a regressive tax.