A progressive tax, or graduated tax, is a tax that is larger as a percentage of income for those with larger incomes. It is usually applied in reference to income taxes, where people with more income pay a higher percentage of it in taxes. The term progressive refers to the way the rate progresses from low to high, but over time it has become confused with modern.
The opposite of a progressive tax is a regressive tax. In this case, the amount of the tax is smaller as a percentage of income for people with larger incomes. Many taxes other than the income tax tend to be regressive in practice: e.g. most sales taxes (since lower income people spend a larger portion of their income), social security taxes (because they exclude interest, rent, and other kinds of income common for the affluent), excise taxes, and so on. (A flat tax, also called a proportional tax, is one where the tax amount is fixed as a function of income, and is a term mainly used only in the context of income taxes.)
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There are two main arguments for a progressive tax system. First, 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 vertically equitable, those with higher incomes must be taxed at a higher rate.
Second, it is argued that people with higher income tend to have a higher percentage of that in disposable income, and can thus afford a greater tax burden. A person making exactly enough money to pay for food and housing cannot afford to pay any taxes without it causing material damage, while someone making twice as much can afford to pay up to half their income to taxes. In practice, however, few if any jurisdictions have taxes that are that extremely progressive; if they did, the higher earner would have nothing to lose by taking half of the year off, which is obviously socially undesirable.
The converse argument is that too progressive a tax rate acts as a disincentive to work; in the previous (extreme) example, there would be no monetary incentive at all for the first person to try to double his or her income. In practice, however, no advocates of a progressive tax go as far as that extreme example, so they often argue that the taxes they propose have very little effect (or even no effect at all) on incentives.
Opponents also claim that progressive taxation shifts the total economic production of society away from capital investiments (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 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 possiblities.
Marginal and average tax rates
The rate of tax can be expressed in two different ways, the marginal rate expressed as the rate on each additional piece of income and the average rate expressed as the total tax paid divided by total income.
In most progressive tax systems, both rates will rise as income rises, though there may be income ranges where the marginal rate will be constant.
However, with a system of negative income tax, refundable tax credits, or income-tested welfare benefits, it is possible for marginal rates to fall as income rises: this can still be seen as progressive providing that the marginal rate is higher than the average rate at any particular level of income, since the average rate will rise as income rises; high marginal rates for those on low incomes can lead to a poverty trap within a progressive system, even if they face negative average rates.
Personal Income Tax Brackets
For example, in the United States as of 2004 there are six "tax brackets" that are used to calculate the percentage of taxable income that must be paid to the United States Treasury. For the unmarried, these percentages in 2003 and 2004 are:
- 10%: $2,651 – $9,700
- 15%: $9,701 – $30,800
- 25%: $30,801 – $68,500
- 28%: $68,501 – $148,700
- 33%: $148,701 – $321,200
- 35%: $321,201 and up
If an individual's 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 who earned $10,000 in 2003 would be liable for 10% of each dollar earned from the 2,651st dollar to the 9,700th dollar, and then for 15% of each dollar earned from the 9,701st dollar to the 10,000th dollar, for a total of $749.75. This ensures that every rise in a person's salary results in an increase of after-tax salary. As such, contrary to a popular belief, there is no point at which one is better off earning less money (or giving to charity to obtain deductions).
An annual after tax income of $27,000 results in a tax cost of
- 30,800 (gross income)
- (9,700–2,651)*0.1=704.9 (bracket 1)
- (30,800–9,701)*0.15=3,164.85 (bracket 2)
- 704.9+3,164.85=3,869.75 (income tax excluding social security tax)
- 30,800*0.12=3,696 (social security tax)
- 3,869.75+3,696=7,565.75 (tax on income including social security tax)
- 30,800–3,869.75=26,930.25 (after tax income)
$7,566 (28% of after tax income) (includes "social security" of 12%, income tax of 13%).
- 31% (federal and state tax) + 200 kronor: 0 – 291,800 kronor ($0 – $41,700)
- 31% + 20% (federal tax) + 200 kronor: 291,800 – 441,300 kronor ($41,700 – $63,000)
- 31% + 25% (federal tax) + 28,280 kronor: 441,300 and up ($63,000 -)
Income tax is payed on the amount that falls within each bracket. To ensure that each increase in gross income is accompanied by an increase in net income.
An annual after tax income of 190,000 kronor ($27,000) results in a tax cost of
- 500,000 (gross income)
- 500,000*0.62=228,255 (income tax excluding social security tax)
- 500,000*0.33=165,000 (social security tax)
- 310,000+165,000=393,255 (tax on income (income tax and social security tax))
- 500,000–310,000=271,745 (after-tax income)
393,255 kronor (145% of after-tax income) (includes "social security" of 33%, effective income tax of 46%).
- 20.7% up to $38,000
- 34.2% from $38,001 to $60,000
- 40.2% above $60,001
- 46.2% when the employee does not complete a declaration form (IR330)
In New Zealand the income is taxed by the amount that falls within each tax bracket. In other words if a person earns $60,000 they will only pay 34.2% on the amount that falls between $38,001 and $60,000 rather than paying this on the full $60,000.
Problems, alternatives, similar concepts
An alternate system of having taxes with an increasing relative rate is a negative income tax, which eliminates the step problem.
Tax progressivity or regressivity should not be confused with two similar concepts: tax neutrality and tax incidence. Tax neutrality refers to whether similar things are taxed in similar ways; if for example taxes on gasoline and diesel are different then this will probably lead to a distortion in demand between the two fuels. If the tax system does not distort demand then it is said to be neutral. Tax incidence refers what group ultimately bears the burden of a tax. For example, sales taxes, which are nominally applied to businesses, are passed through to consumers as higher prices – although the degree to which a sales tax is passed on to the consumer depends on elasticity, and one can measure the effective progressivity of a tax by income group as well as breaking the impact down by geographic area or other factors.