Proportional, Progressive, and Regressive taxes

July 8th, 2010

Taxes are differentiated by the impact they have on the distribution of income and wealth. A proportional tax is a kind that imposes the same relative requirement on each taxpayer—i.e., when tax liability and income increase in relative proportion. A progressive tax is characterized by a larger than proportional growth in the tax burden relative to the growth in income, and a regressive tax is recognised by a less than proportional growth in the relative liability. Therefore, progressive taxes are regarded as reducing a lack of equality in income distribution, whereas regressive taxes are found to increase these inequalities.

The taxes that are normally regarded as progressive include individual income taxes and estate taxes. Income taxes that are initially progressive, however, might become less so in the upper-income categories—particularly if a taxpayer is able to lessen his tax base by nominating deductions or by excluding some particular income elements from his taxable income. Proportional tax rates if applied to lower-income groups could also be more progressive if such exemptions of a personal nature are made.

Income measured over a given period might not absolutely provide the most accurate measure of taxpaying status. For example, transitory increases in income can be saved, and within temporary declines in income a taxpayer may choose to finance consumption by reducing savings. Therefore, if taxation is made comparable alongside “permanent income,” it would be less regressive (or more progressive) than if it is made comparable with annual income.

Sales taxes and excises (save luxuries) are mostly regressive, because the spread of personal income consumed or spent on a specific good lowers as the rate of personal income increases. Poll taxes (also called head taxes), levied as a fixed amount per capita, clearly are regressive.

It is not easy to term corporate income taxes and taxes on business as progressive, regressive, or proportionate, due to the uncertainty around the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of nominating who bears the tax burden lays fundamentally on whether a national or a subnational (that is, provincial or state) tax is being considered.

In assessing the economic effect of taxation, it is necessary to differentiate between several concepts of tax rates. The statutory rates are those dictated in legislature; generally these are marginal rates, but in some cases they are mean rates. Marginal income tax rates indicate the fraction of incremental income that is demanded by taxation when income grows by one dollar. Hence, if tax liability rises by 45 cents when income increases by one dollar, the marginal tax rate is 45 percent. Income tax laws usually contain graduated marginal rates—i.e., rates that increase as income grows. Careful analysis of marginal tax rates should take into account provisions other than the formal statutory rate structure. If, for example, a particular tax credit (reduction in tax) reduces by 20 cents for each one-dollar growth in income, the marginal rate is 20 percentage points greater than nominated by the statutory rates. Since marginal rates display how after-tax income is changed in response to changes in before-tax income, they are the appropriate ones for appraising incentive effects of taxation. It is even more difficult to nominate the marginal effective tax rate to apply to income from business and capital, as it may depend on factors including the structure of depreciation allowances, the deductibility of interest, and the provisions for inflation adjustment. A basic economic theorem shows that the marginal effective tax rate in income from capital is zero under a consumption-based tax.

Average income tax rates display the part of total income that is paid in taxation. The pattern of average rates is the one that is necessary for judging the distributional equity of taxation. Under a progressive income tax the average income tax rate increases with income. Average income tax rates usually increase with income, both because personal allowances are granted for the taxpayer and dependents and because marginal tax rates are graduated; on the flip side, preferential treatment of income received for the most part by high-income households might swamp these effects, producing regressivity, as signified by average tax rates that fall as income increases.

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