Answer to Question #162780 in Microeconomics for Amna

Question

An individual earns wage income (W) at the rate of Rs. 30,000 per month. He also owns physical assets 

that were worth Rs. 600,000 at the beginning of the fiscal year but now have a market value of 690,000. 

The individual’s income tax liability is determined under a proportional tax system (with ATR = MTR = 

7.5% ) on the basis of his net worth at the end of the fiscal year. He is also subject to paying wealth tax @ 

2% per annum and a capital gains tax @ 1.5% per annum. Calculate total tax liability of the individual 

when the tax system allows for 

(a) zero inflation, and 

(b) 12% inflation.

On the basis of your calculations, explain what is the correct way of taxing capital gains in the presence of 

inflation?

Answer 1

i)                   Tax Liability with Zero inflation

Income tax liability

=net income X proportional tax

Net income = Rs. 30,000 X 12

               =Rs. 360,000

Tax = 7.5%

               =360,000 X 0.075

=Rs. 27,000

Capital gain tax

Capital gain = Rs. 690,000 – Rs. 600,000

               = Rs. 90,000

Tax = 1.5%

= 0.015 X 90,000

=Rs. 1350

Wealth tax

Total wealth = net income+ net assets

               = Rs. (360,000 + 690,000)

= Rs. 1,050,000

Tax = 2%

=0.02 X 1,050,000

=Rs. 21,000

Total Tax liability

=income tax + capital gain tax + wealth tax

=Rs.(27,000+1,350+21,000)

               =Rs. 49,350

ii)                 Taxation with 12% inflation

Income tax liability

=net income X proportional tax

Net icome = Rs. 30,000 X 12

               =Rs. 360,000

Inflation = 12%

=0.12 X 360,000

= Rs. 43,200

Taxable income = net income – inflation

=Rs. (360,000 – 43,200)

= Rs. 316,800

Tax = 7.5%

               =316,800 X 0.075

=Rs. 23,760

Capital gain tax

Capital gain = Rs. 690,000 – Rs. 600,000

               = Rs. 90,000

Inflation = 12%

=0.12 X 90,000

= Rs. 10,800

Taxable gains = total gains – inflation

=Rs. (90,000 – 10,800)

= Rs. 79,200

Tax = 1.5%

= 0.015 X 90,000

=Rs. 1,188

Wealth tax

Total wealth = net income+ net assets

               = Rs. (360,000 + 690,000)

= Rs. 1,050,000

Inflation = 12%

=0.12 X 1,050,000

= Rs. 126,000

Taxable income = net wealth – inflation

=Rs. (1,050,000 – 126,000)

= Rs. 924,000

Tax = 2%

=0.02 X 1,050,000

=Rs. 18,480

Total Tax liability

=income tax + capital gain tax + wealth tax

=Rs. (23,760+1,188+18,480)

               =Rs. 43,428