Progressive tax

A progressive tax is a tax by which the tax rate increases as the taxable base amount increases.^{[1][2][3][4][5]} "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.^[6][7] 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 would create progressive distributional 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.^[8][9][10]

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.^[11]

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. Sales taxes are often criticized because low income households must pay a greater share of their disposable income to a sales tax than wealthier households.^[12][13] In between is a proportional tax, where the tax rate is fixed as the amount subject to taxation increases.^[5]

History of intellectual debate

The idea of a progressive tax has garnered support from macro economists and political scientists of many different ideologies - ranging from Adam Smith to Karl Marx, although there are differences of opinion about the optimal level of progressivity. Some economists^[14] trace the origin of modern progressive taxation to Adam Smith, who wrote in The Wealth of Nations:

The necessaries of life occasion the great expense of the poor. They find it difficult to get food, and the greater part of their little revenue is spent in getting it. The luxuries and vanities of life occasion the principal expense of the rich, and a magnificent house embellishes and sets off to the best advantage all the other luxuries and vanities which they possess. A tax upon house-rents, therefore, would in general fall heaviest upon the rich; and in this sort of inequality there would not, perhaps, be anything very unreasonable. It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.^[15]

The French Declaration of the Rights of Man and of the Citizen of 1789 agrees:

A common contribution is essential for the maintenance of the public forces and for the cost of administration. This should be equitably distributed among all the citizens in proportion to their means.^[16]

In most western European countries and the United States, advocates of progressive taxation tend to be found among the majority of economists and social scientists, many of whom believe that completely proportional taxation is not a possibility.^[17][18] In the U.S., an overwhelming majority of economists (81%) support progressive taxation.^[17] Given the diversity of systems that fall under this category and the number of different possible rates, this is not surprising.^[18]

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.

• A progressive tax reduces income inequality, which has been reported to have a number of societal benefits, such as lower homicide rates at all income levels.^[19] A steeper progressive income tax results in an even more equal distribution of income across the board. The difference between the Gini index for an income distribution before taxation and the Gini index after taxation is an indicator for the effects of such taxation. Richard G. Wilkinson argues that in a more unequal society, even middle class people on good incomes are likely to be less healthy, less likely to be involved in community life, more likely to be obese, and more likely to be victims of violence.^[20] Amongst the wealthiest quarter of countries, there is no relation between a country's wealth and general population health, but within a country, relative levels can have an effect.^[21]

• 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^[22]

• 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). Some would claim that 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).

Arguments against implementation

• It has been argued that progressive taxation violates the principle of equality under the law.^[23]
• 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).
  • The classical argument against progressive taxation runs as follows:

    The diminishing returns argument applies to the fraction of income used for present consumption. As income rises, diminishing returns implies that a smaller and smaller fraction of income will be spent on consumption goods. The remaining income will (of necessity) be used to purchase capital goods. This acts as a form of positive feedback that in turn yields more income for capital spending. Meanwhile (and because) these capital goods induce a decline in the costs of production which has the effect of raising real wages generally and implicitly raising the general standard of living. The income paid back on the capital helps create the disincentive to consume that creates capital spending. Thus, those capitalists who effectively manage their property are rewarded and given control of more (newly created) property, of which they are increasingly less inclined to consume and increasingly more inclined to purchase capital goods and thus further elevate the general standard of living by driving down the costs of production. As they acquire more capital goods, eventually their ownership outstrips their ability to manage and oversee what they own; however, they control only as many capital goods as can be attributed to the income of their prior capital---which previously did not exist. Therefore, their ownership does not negatively contribute to the general standard-of-living relative to counterfactual state of them not purchasing those goods. It would thus be misleading to argue that redistributing their capital may yield further increases in the standard-of-living. Doing so may well cause that effect, but doing so neglects that it was the assumption that redistribution would not happen that induced the accumulation of capital. — Eugen von Böhm-Bawerk, Karl Marx and the Close of his System, 1896

  • A belief that 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.
• Brain drain and tax avoidance. High progressive taxes may encourage emigration because taxes are not internationally harmonized, so very high earners are sometimes able to relocate in order to pay less tax, or find tax havens for their income. Unlike the opposing income effect and substitution effect of leisure which may make tax progressivity neutral in terms of working hours, the emigration rate must increase with the top rates of tax.^{[citation needed]}
  • The differential in the higher rates of tax between the United States and Europe are cited as a factor in the "brain drain" of high-earners to America in the 1960s, and is considered an important influence on modern "economic migration."^{[citation needed]}
• Increase in tax loopholes such as income splitting techniques.^{[citation needed]} 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.
• The increasing energy expended on tax avoidances which occur with greater progressivity produces an increase in the work of accountants and lawyers. Because tax avoidance creates no net wealth this work is unproductive, and can make taxes on the rich less efficient than on the middle class, who have less motivation to exploit tax loopholes.^{[citation needed]}
• Progressive taxes are argued to create work disincentive. Consider again someone who makes twice the minimum required to live on but pays all income above the minimum living threshold in taxes. Such a person had no monetary incentive at all to try to increase his or her income above the base level.^[24]
• 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^[25] 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)^[26]
• A study from the libertarian Institute for Policy Innovation, which aims to reduce government intervention in the economy, has concluded that progressive taxes fail to decrease real income inequality.^[27]
• Some^[who?] libertarians, especially anarcho-capitalists, argue that only poll taxes can be economically efficient^[28] in the fullest sense (the utilitarian view), and/or that equity requires each citizen to pay the full exchange value in trade for governance services such as the guarantee of property rights (the natural rights viewpoint).

Measuring progressivity

Models 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.^[29]

Effective progression

An effective progression^[30] can be computed from inequality measures. The following example uses the Gini coefficient:

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.^[31] 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. One example is the United States Alternative Minimum Tax; since it is not indexed to inflation,^[32][33] an increasing number of upper-middle-income taxpayers have been finding themselves subject to this tax.

Marginal and effective tax rates

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.^{[citation needed]}

Base of taxation

Income

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.^[34][35] 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.^[8][9][10] 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."^[35] 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

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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.^[36] 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. All values in New Zealand dollars and exclude the earner levy.

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

Notes

External links

Wikimedia Commons has media related to: Marginal tax rates

Wikiquote has a collection of quotations related to: Taxation

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