Proportional, Progressive, and Regressive taxes
Taxes are differentiated by the effect they have on the distribution of income and wealth. A proportional tax is the kind of tax that impinges the same relative requirement on all the taxpayers—i.e., when tax liability and income increase in relative scale. A progressive tax is recognised by a larger than proportional growth in the tax liability relative to the increase in income, and a regressive tax is recognised by a less than proportional growth in the relative liability. Hence, progressive taxes are viewed as taking away inequalities in income distribution, but regressive taxes may cause an increase in these inequalities.
The taxes that are usually regarded as progressive include individual income taxes and estate taxes. Income taxes that are nominally progressive, however, may become less so for the upper-income class—especially if a taxpayer is allowed to lower his tax base by nominating deductions or by leaving out certain income components from his taxable income. Proportional tax rates when applied to lower-income categories would also be more progressive if such personal exemptions are declared.
Income measured over the course of a given year does not necessarily provide the most accurate measure of taxpaying ability. For example, transitory increases in income might be saved, and in temporary declines in income a taxpayer may elect to finance consumption by taking from savings. Thus, if taxation is compared with “permanent income,” it should be less regressive (or more progressive) than if compared with annual income.
Sales taxes and excises (except those on luxuries) are generally regressive, because the dissemination of individual income consumed or spent on a specific good lessens as the level of personal income rises. Poll taxes (aka head taxes), levied as a standard amount per capita, clearly are regressive.
It is complicated to dictate corporate income taxes and taxes on business as progressive, regressive, or proportionate, principally because of uncertainty surrounding the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of determining who bears the tax burden rests crucially on whether a national or a subnational (that is, provincial or state) tax is being decided.
In analysing the economic purposes of taxation, it is essential to distinguish between several concepts of tax rates. The statutory rates will be dictated in the legislation; generally speaking these are marginal rates, but for some cases they are average rates. Marginal income tax rates note the fraction of incremental income demanded by taxation when income rises by one dollar. Therefore, if tax liability rises by 45 cents when income rises by one dollar, the marginal tax rate is 45 percent. Income tax legislation generally contain graduated marginal rates—i.e., rates that grow as income rises. Heavy analysis of marginal tax rates are required to review provisions in addition to the formal statutory rate structure. If, for example, a particular tax credit (reduction in tax) lowers by 20 cents for each one-dollar increase in income, the marginal rate is 20 percentage points more than indicated in the statutory rates. Since marginal rates signify how after-tax income moves in response to changes in before-tax income, they are the appropriate ones for considering incentive effects of taxation. It is even more difficult to know the marginal effective tax rate applied to income from business and capital, since it may rely on such considerations as the structure of depreciation allowances, the deductibility of interest, and the provisions for inflation adjustment. A basic economic theorem grants that the marginal effective tax rate in income from capital is zero under a consumption-based tax.
Average income tax rates signify the part of total income that is required in taxation. The pattern of average rates is the one that is important for judging the distributional equity of taxation. Under a progressive income tax the average income tax rate increases with income. Average income tax rates commonly grow with income, both because personal allowances are granted for the taxpayer and dependents and also due to that marginal tax rates are graduated; conversely, preferential treatment of income received fundamentally by high-income households may swamp these effects, forcing regressivity, as shown by average tax rates that decrease as income increases.
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