Proportional, Progressive, and Regressive taxes

July 8th, 2010

Taxes can be differentiated by the effect they have on the allocation of income and wealth. A proportional tax is a tax that applies the same relative onus on every taxpayer—i.e., when tax liability and income increase in the same proportion. A progressive tax is characterizable by a larger than proportional rise in the tax liability in relation to the increase in income, and a regressive tax is characterizable by a less than proportional growth in the comparable onus. So, progressive taxes are seen as taking away the lack of equality in income distribution, whereas regressive taxes are seen to cause an increase in these inequalities.

The taxes that are generally thought to be progressive include individual income taxes and estate taxes. Income taxes that are initially progressive, however, may become less so in the upper-income demographic—in particular if a taxpayer is able to lessen his tax base by claiming deductions or by removing some particular income elements from his taxable income. Proportional tax rates that are applied to lower-income classes would also be more progressive if such personal exemptions are declared.

Income measured over the period of a year does not necessarily come up with the most suitable measure of taxpaying status. For example, transitory rises in income may be saved, and within temporary declines in income a taxpayer could choose to provide for consumption by reducing savings. So, if taxation is held in comparison alongside “permanent income,” it would be less regressive (or more progressive) than when held in comparison with annual income.

Sales taxes and excises (save on luxuries) are generally regressive, because the spread of one’s income consumed or spent for a specific good declines as the rate of personal income grows. Poll taxes (aka head taxes), calculated as a fixed amount per capita, patently are regressive.

It is complicated to determine corporate income taxes and taxes on business as progressive, regressive, or proportionate, principally due to a lack of certainty about the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of deciding who bears the tax burden depends for the most part on whether a national or a subnational (that is, provincial or state) tax is being debated.

In considering the economic purpose of taxation, it is important to differentiate between differing points of tax rates. The statutory rates will be dictated in law; generally these are marginal rates, but occasionally they are median rates. Marginal income tax rates signify the fraction of incremental income that is taken by taxation when income is increased by one dollar. So, if tax liability increases by 45 cents when income increases by one dollar, the marginal tax rate is 45 percent. Income tax regulations commonly contain graduated marginal rates—i.e., rates that rise as income rises. Careful analysis of marginal tax rates need to take into account provisions as well as the formal statutory rate structure. If, for example, a particular tax credit (reduction in tax) decreases by 20 cents for each one-dollar rise in income, the marginal rate is 20 percentage points more than nominated in the statutory rates. Since marginal rates signify how after-tax income is changed in response to changes in before-tax income, they are the appropriate ones for regarding incentive effects of taxation. It is even more difficult to realise the marginal effective tax rate to apply to income from business and capital, because it may depend on considerations such as the structure of depreciation allowances, the deductibility of interest, and the provisions for inflation adjustment. A basic economic theorem determines that the marginal effective tax rate in income from capital is zero under a consumption-based tax.

Average income tax rates show the part of total income that is paid in taxation. The pattern of average rates is the one that is relevant for appraising the distributional equity of taxation. Under a progressive income tax the average income tax rate rises with income. Average income tax rates usually increase with income, both because personal allowances are provided for the taxpayer and dependents and also due to that marginal tax rates are graduated; conversely, preferential treatment of income received predominantly by high-income households can swamp these effects, forcing regressivity, as signified by average tax rates that fall as income rises.

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