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Progressive taxation

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Progressive taxation

A progressive tax is a tax in which the tax rate increases as the taxable base amount increases.[1][2][3][4][5] The term "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] The term can be applied to individual taxes or to a tax system as a whole; a year, multi-year, or lifetime. Progressive taxes are imposed in an attempt to reduce the tax incidence of people with a lower ability-to-pay, as such taxes shift the incidence increasingly to those with a higher ability-to-pay. 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.[5]

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.[8][9][10]

History

The earliest known application of progressive taxation took place in Great Britain in the 14th century.[11] 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income tax was established by the Revenue Act of 1862, which was signed into law by President Abraham Lincoln and repealed the short-lived flat tax contained in the Revenue Act of 1861.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,[12]

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.[13]

Effective progression

An effective progression[14] can be computed from inequality measures. The following example uses the Gini coefficient:

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

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 the amount subject to taxation rises.

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.

Economic effects

Income equality

Progressive taxation reduces absolute income inequality when the higher rates on higher-income individuals are paid and not evaded, and transfer payments and social safety nets result in progressive government spending.[15][16][17] 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.[18][19] These principles have recently been confirmed by game theoretic economic models.[20]

Effects on educational choices

A potentially adverse effect of progressive tax schedules is their distorting effect on educational choices. By reducing the after-tax income of highly educated workers, progressive taxes reduce the incentives for citizens to attain education and can thereby lower the overall level of human capital in an economy.[21] A related notion is the Davis-Moore hypothesis, which argues that inequality serves social stability.[22] However, public subsidy of college tuition can increase the net present value of income tax receipts because college educated taxpayers earn much more than those without college education.[23]

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."[24]

Examples


Most systems around the world contain progressive aspects. When taxable income falls within a particular tax bracket, the individual pays the listed percentage of tax 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. In the United States, there are five tax brackets ranging from 10% to 35%.

New Zealand has the following income tax brackets (for the 2012–2013 financial year): 10.5% up to NZ$14,000; 17.5% from $14,001 to $48,000; 30% from $48,001 to $70,000; 33% over $70,001; and 45% when the employee does not complete a declaration form.[25] All values are in New Zealand dollars and exclude the earner levy.

Australia has the following progressive income tax rates (for the 2012–2013 financial year): 0% effective up to A$18,200; 19% from $18,201 to $37,000; 32.5% from $37,001 to $80,000; 37% from $80,001 to $180,000; and 45% for any amount over $180,000.[26]

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.[27]

See also

References

External links

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