Progressive tax

A progressive tax is a tax in which the tax rate increases as the taxable base amount increases. "Progressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from low to high, where the average tax rate is less than the marginal tax rate. It can be applied to individual taxes or to a tax system as a whole; a year, multi-year, or lifetime. Progressive taxes attempt to reduce the tax incidence of people with a lower ability-to-pay, as they shift the incidence increasingly to those with a higher ability-to-pay.

The term is frequently applied in reference to personal income taxes, where people with more income pay a higher percentage of that income in tax than do those with less income. It can also apply to adjustment of the tax base by using tax exemptions, tax credits, or selective taxation that creates progressive distribution effects. For example, a sales tax on luxury goods or the exemption of basic necessities may be described as having progressive effects as it increases a tax burden on high end consumption or decreases a tax burden on low end consumption respectively.

Progressive taxation often must be considered as part of an overall system since tax codes have many interdependent variables. For example, when refundable tax credits and other tax incentives are included across the entire income spectrum, the United States has the most progressive income tax code among its peer nations; although its overall income tax rates are below the OECD average.

The opposite of a progressive tax is a regressive tax, where the relative tax rate or burden increases as an individual's ability to pay it decreases. In between is a proportional tax, where the tax rate is fixed as the amount subject to taxation increases.

History

The earliest known application of progressive taxation took place in Great Britain in the 14th century. In the United States, the first progressive income tax was established by the Revenue Act of 1862, which was signed into law by President Abraham Lincoln and repealed the short-lived flat tax contained in the Revenue Act of 1861.

Overview

In the preface of the book, Tax Progressivity and Income Inequality, Professor of Economics Joel Slemrod writes,

The question of tax progressivity – who should bear the tax burden – has fascinated tax philosophers for over a century, and remains highly controversial... The ultimate answer to this question depends on ethical judgments into which the field of economics offers no insight, but it also depends on some of the bread-and-butter preoccupations of economics, such as the extent and nature of income inequality and the behavioral response of taxpayers to alternative tax systems.

Measuring progressivity

Indices such as the Suits index, Gini coefficient, Theil index, Atkinson index, and Robin Hood index are sometimes used to factor progressivity through measures of inequality of income distribution or inequality of wealth distribution.

Effective progression

An effective progression can be computed from inequality measures. The following example uses the Gini coefficient:

$r_{Gini}={\frac {1-G_{net}}{1-G_{gross}}}$

Inflation and tax brackets

Many tax laws are not accurately indexed to inflation. Either they ignore inflation completely, or they are indexed to the Consumer Price Index (CPI), which tends to understate real inflation. In a progressive tax system, failure to index the brackets to inflation will eventually result in effective tax increases (if inflation is sustained), as inflation in wages will increase individual income and move individuals into higher tax brackets with higher percentage rate. This phenomenon is known as bracket creep, and can cause fiscal drag

One example is the United States Alternative Minimum Tax; since it is not indexed to inflation, an increasing number of upper-middle-income taxpayers have been finding themselves subject to this tax. Another example is the stamp duty in the United Kingdom on sale of residential housing (from 2003 instead stamp duty land tax); due to the United Kingdom housing bubble and the lack of change in brackets (until 2005), an increasing number of sales fell into higher brackets.

Marginal and effective tax rates

Main articles: Marginal tax rate and Effective tax rate

The rate of tax can be expressed in two different ways, the marginal rate expressed as the rate on each additional unit of income or expenditure (or last dollar spent) and the effective (average) rate expressed as the total tax paid divided by total income or expenditure. In most progressive tax systems, both rates will rise as amount subject to taxation rises, though there may be ranges where the marginal rate will be constant. With a system of negative income tax, refundable tax credits, or income-tested welfare benefits, it is possible for marginal rates to fall as amount subject to taxation rises: this can still be seen as progressive providing that the marginal rate is higher than the average rate at any particular level, since the average rate will rise; high marginal rates for those with low means can lead to a poverty trap within a progressive system, even if they face negative average rates.

Progressive taxes most commonly refer to systems where the marginal tax rate is non-decreasing, meaning that the marginal tax on each additional unit of taxable base (e.g., income) is at least as much as the previous unit, and possible more, but never less. This is most often accomplished by tax brackets, where the marginal rate is constant over a range (the "bracket"), then increases in the next bracket.

Variant systems

While most commonly progressive taxes have non-decreasing marginal rates, so the marginal rate increases or stays constant, often in a stair-step pattern, and consequently the effective rate (which accumulates and averages the marginal rates) increases smoothly, there are exceptions. In these cases other phenomena may occur – for instance, the marginal rate may increase and then decrease, or the effective rate may jump upwards (corresponding to a very high or effectively infinite marginal tax rate).

For example, in US income tax, there was a "bubble rate" from 1987–1990 (from the income tax rates of the Tax Reform Act of 1986 until rescinded in the Omnibus Budget Reconciliation Act of 1990). In this case the headline tax brackets were 15% and 28%, but in fact were 15/28/33/28, where beyond a certain threshold the 28% rate was applied to income that had previously been taxed at 15% (the portion subject to the 28% rate rose gradually, as determined by the 33% bracket). Once this 28% rate covered all income, the 33% bracket ended and the 28% rate applied, thus effecting a 28% flat tax for taxpayers in this top bracket.

In UK stamp duty land tax on transfer of residential real estate, as of 2003, the progressive tax brackets apply to the effective rate, not the marginal rate; this is known as the "slab" system. For example, initially the threshold was £60,000: below this there was a 0% rate, above this a 1% rate on the entire amount. Thus a £60,000 house would have £0 tax, but a £60,001 house would have £600 (and 1p) tax, for an effective price of £60,601. This has been criticized as causing distortions for housing unit whose price is near these cut-offs.

Economic effects

Progressive taxation has a variety of economic effects.

Income inequality

Progressive taxation reduces absolute income inequality. This claim assumes that the higher rates on higher-income individuals is what is actually paid and not evaded. When income inequality is low, aggregate demand will be relatively high, because more people who want ordinary consumer goods and services will be able to afford them, while the labor force will not be as relatively monopolized by the wealthy. For example, in 1950, U.S. federal taxes were 14% of GDP, the top income tax bracket rate was effectively 88%, and jobs grew by 7.7%; in contrast during 2012, federal taxes were 19% of GDP, the top tax bracket rate was 35% (but effectively much less) while jobs only grew 1.4%.

Psychological effects

In a study published in 2011, which included the use of data from 54 countries, the authors stated, "our results showed that progressive taxation was positively associated with the subjective well-being of nations", later adding, "we found that the association between more-progressive taxation and higher levels of subjective well-being was mediated by citizens’ satisfaction with public goods, such as education and public transportation."

Base of taxation

Income

Graph demonstrates a progressive tax distribution on income that becomes regressive for top earners.

The key concept of progressive income taxation is that income is considered in different steps, where income earned between certain points will be taxed at a certain rate. This is done to avoid creating incentive traps, where earning more might actually decrease your income (e.g., if income up to 10,000 is untaxed and after 10,001 you pay 10%, you will receive 9,000.90 if you make 10,001 and 10,000 if you make 10,000). The size and severity of the different steps varies a great deal and the differences inside the term "progressive" can be enormous. In this sense, it is not surprising that most economists support progressive taxation to some degree - the primary differences come when looking at the maximum income taxes that the highest earners might have to pay.

Expenditure

While a tax on expenditures can be structured like a pure sales tax, many proposals make adjustments to decrease regressive effects. Using exemptions, graduated rates, deductions, credits or rebates, a consumption tax can be made less regressive or progressive, while allowing savings to accumulate tax-free. A sales tax on luxury goods or the exemption of basic necessities may be described as having progressive effects as it increases a tax burden on high end consumption or decreases a tax burden on low end consumption respectively. Economist Alan J. Auerbach of University of California, Berkeley states that "annual income is not an especially accurate measure of one's ability to pay. A household's consumption tends to fluctuate less from year to year than its income does, and in some respects offers a better measure of a family's sustainable standard of living. Averaged over periods longer than one year, which smoothes out fluctuations in annual income, consumption taxes look less regressive relative to income than they look on an annual basis." Tax reform proposals that transition from an income tax to a consumption tax would be more equitable because consumption requires a balance between known and complex social costs.

Implementation

There are various ways that a progressive income tax can be implemented:

Increasing percentage rates

When implementing a progressive tax with increasing percentage rates, the percentage of tax of each dollar increases as the total revenue (or income) increases. For example, a tax of 15% on all income earned up to $50,000, plus a tax of 25% on each dollar earned between $50,001 and $100,000, plus a tax of 34% of all income earned above $100,000. The United States currently uses increasing percentage rates in the form of tax brackets.

Single tax rate

A progressive tax rate can also be achieved by combining a single flat rate with a threshold (or deduction). For example, all income up to $100,000 is earned tax free; income above $100,000 is taxed at 35%.

Formula

A progressive tax rate can also be achieved by mathematical formula. A simple progressive tax is described by a linear equation of the form y=mx+b, relating tax rate y to income x with the slope m being greater than zero. Setting the slope m to zero would convert this to a flat tax. A progressive tax by formula can also implement a negative income tax by setting the y-axis intercept b to a value less than zero. No additional verbiage is needed to implement a negative income tax within a progressive tax system. Tax rates can be altered as often as needed by simply adjusting the values of the variables in the equation, no rewriting of tax laws, codes, etc. are needed. More complex progressive systems can be created by using a non-linear equation.

Examples

Distribution of U.S. federal taxes for 2000 as a percentage of income among the family income quintiles, with richer groups paying more

Most systems around the world contain progressive aspects. New Zealand has the following income tax brackets (as of 1 October 2008): 12.5% up to NZ$14,000, 21% from $14,001 to $40,000, 33% $40,001 to $70,000, 39% over $70,001, and 45% when the employee does not complete a declaration form. All values in New Zealand dollars and exclude the earner levy. Australia has the following progressive income tax brackets: 0% effective up to A$6000 (PAYG taxed at 15% then fully rebatable at the end of the financial year), 15% from $6001 to $25000, 30% from $25001 to $75000, 40% from $75001 to $150000, and 45% tax for any amount over $150000.

In the United States, there are five "tax brackets." ranging from 10% to 35%. used to calculate the percentage of taxable income (of individuals).

If taxable income falls within a particular tax bracket, the individual pays the listed percentage of income on each dollar that falls within that monetary range. For example, a person in the U.S. who earned $10,000 US of taxable income (income after adjustments, deductions, and exemptions) would be liable for 10% of each dollar earned from the 1st dollar to the 7,550th dollar, and then for 15% of each dollar earned from the 7,551st dollar to the 10,000th dollar, for a total of $1,122.50. This ensures that every rise in a person's salary results in an increase of after-tax salary.

See also: Tax rates around the world

Arguments

For implementation

• The higher one's income, the greater the fraction of it that tends to consist of economic rent rather than rewards for any commensurate contribution to production. By definition, economic rent is a factor payment exceeding that required to place a factor in its most productive use, so it can be taxed away entirely without impairing wealth production. Consequently, in the absence of taxes specifically levied on economic rent, a steeply progressive tax on the highest incomes can be expected to fall almost exclusively on economic rent, minimizing the excess burden of such taxation.

• In a market economy, the larger an investment is, the higher its rate of return. This is due to both economies of scale and the increased range of investment opportunities. In addition to these economic forces, those who control greater amounts of capital within a society are able to participate more directly in shaping government policy, often in ways that further maximize their wealth. Thus, due to both economic and political realities within a market economy, it is a natural process for the wealthiest individuals and firms in a society to become disproportionately wealthier over time. In order to prevent the political instability resulting from the natural stratification of the populace into an ever smaller and wealthier aristocracy or moneyed class, and an ever larger working class, free market democracies should support progressive taxation and programs to enhance economic opportunity for the lower and middle classes.

• In response to the concern that progressive taxation creates an unfair psychological burden on the wealthy; if the utility gained from income exhibits diminishing marginal returns, as many psychologists assert (see Weber-Fechner law), then for the tax burden to be shared in a utilitarian way the tax-bill must increase non-linearly with income.

• As income levels rise, marginal propensity to consume tends to drop. Thus it is often argued that economic demand can be stimulated by reducing the tax burden on lower incomes while raising the burden on higher incomes.

• People with higher income tend to have a higher percentage of that in discretionary income, and can thus afford a greater tax burden (this is the “vertical equity” argument), e.g., a person earning exactly enough money to pay for food and housing cannot afford to pay any taxes without its causing material damage, while someone earning twice as much can afford to pay up to half their income in taxes.

• Some believe that the wealthy have a disproportionately greater interest in maintaining societal goods typically supported by taxation such as security of property rights, defense and infrastructure, as they have much more to lose if these fail than do the poor. Public investments in defense and foreign aid often support assets abroad whose expropriation is a far greater risk than is the risk involving domestic investments.

• As long as after-tax income is a strictly increasing function of gross income, there is a monetary incentive to increase compensation received. Indeed, for any particular income goal, the higher the tax rate, the more compensation one must receive to reach that income goal. For this reason, progressive income tax may increase the incentive to produce among the largest producers (if higher production is truly associated with higher compensation).

Against implementation

• Progressive taxation creates distortions such as labor supply disincentives. Depending on tax rate, the incentive to stay in a lower tax bracket may be higher than one to move in to a higher bracket.

• Regardless of higher nominal tax rates, revenues do not tend to increase with progressive taxation (see Hauser's law).
• Progressive taxation violates the principle of equality under the law.

• Progressive taxes lower savings rates. High-earners have a lower average propensity to consume, so shifting the tax-burden away from them will increase the aggregate savings rate, which should increase steady state growth (if the savings rate is initially below the Golden Rule savings rate).

• Progressive taxation shifts the total economic production of society away from capital investments (tools, infrastructure, training, research) and toward present consumption goods. This could happen because high-income earners tend to pay for capital goods (through investment activities) and low-income earners tend to purchase consumables. Smithian and neo-classical growth theory says that spending more on consumption goods and less on capital goods will slow the rise of the standard of living, and possibly even reduce it since capital goods increase future production possibilities.

• Progressive corporate income tax can increase use of tax loopholes such as income splitting techniques. This creates an incentive for business owners to split their business into smaller, less efficient ones for a lower tax bracket. It also encourages production from less efficient smaller businesses than larger ones.

• Justice in representation: economic equity is sometimes used to argue against progressive taxation, on the grounds of representation being out-of-proportion to taxation: While the top 5% in income in most countries pay over half the taxes they have only 5% of the voting weight. This argument can be reversed into the plutocratic case that if tax is to be progressive it should be accompanied by greater say in elections for those who contribute most.

• Policymakers are argued to be under a pressure from lower and middle income voters to limit higher incomes by the means of progressive taxation. A few economists argue against inequity aversion: "If policy makers' primary goal is … economic prosperity for all, they should avoid focusing on the politics of envy." (Gregory Mankiw)

See also

• Tax incidence
• Laffer curve
• Proportional tax
• Regressive tax
• Robin Hood effect
• Suits index

External links

• The Progressive Income Tax: Theoretical Foundations
• What's Wrong with the Progressive Income Tax