Progressive tax

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A progressive tax is a tax in which the tax rate increases as the taxable amount increases. [1] [2] [3] [4] [5] The term "progressive" refers to the way the tax rate progresses from low to high, with the result that a taxpayer's average tax rate is less than the person's 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 average tax rate or burden decreases as an individual's ability to pay increases. [5]

Contents

The term is frequently applied in reference to personal income taxes, in which people with lower income pay a lower percentage of that income in tax than do those with higher income. It can also apply to adjustments of the tax base by using tax exemptions, tax credits, or selective taxation that creates progressive distribution effects. For example, a wealth or property tax, [8] a sales tax on luxury goods, or the exemption of sales taxes on basic necessities, may be described as having progressive effects as it increases the tax burden of higher income families and reduces it on lower income families. [9] [10] [11]

Progressive taxation is often suggested as a way to mitigate the societal ills associated with higher income inequality, [12] as the tax structure reduces inequality, [13] but economists disagree on the tax policy's economic and long-term effects. [14] [15] [16] One study suggests progressive taxation can be positively associated with happiness, the subjective well-being of nations and citizen satisfaction with public goods, such as education and transportation. [17]

Early examples

In the early days of the Roman Republic, public taxes consisted of assessments on owned wealth and property. The tax rate under normal circumstances was 1% of property value, and could sometimes climb as high as 3% in situations such as war. These taxes were levied against land, homes and other real estate, slaves, animals, personal items and monetary wealth. By 167 BC, Rome no longer needed to levy a tax against its citizens in the Italian peninsula, due to the riches acquired from conquered provinces. After considerable Roman expansion in the 1st century, Augustus Caesar introduced a wealth tax of about 1% and a flat poll tax on each adult, this made the tax system less progressive (as it no longer only taxed wealth). [18]

Modern era

A caricature of William Pitt the Younger collecting the newly introduced income tax. Pitt's income tax.jpg
A caricature of William Pitt the Younger collecting the newly introduced income tax.

The first modern income tax was introduced in Britain by Prime Minister William Pitt the Younger in his budget of December 1798, to pay for weapons and equipment for the French Revolutionary War. Pitt's new graduated (progressive) income tax began at a levy of 2 old pence in the pound (1/120) on incomes over £60 and increased up to a maximum of 2 shillings (10%) on incomes of over £200. Pitt hoped that the new income tax would raise £10 million, but actual receipts for 1799 totalled just over £6 million. [19]

Pitt's progressive income tax was levied from 1799 to 1802, when it was abolished by Henry Addington during the Peace of Amiens. Addington had taken over as prime minister in 1801, after Pitt's resignation over Catholic Emancipation. The income tax was reintroduced by Addington in 1803 when hostilities recommenced, but it was again abolished in 1816, one year after the Battle of Waterloo.

The United Kingdom income tax was reintroduced by Sir Robert Peel in the Income Tax Act 1842. Peel, as a Conservative, had opposed income tax in the 1841 general election, but a growing budget deficit required a new source of funds. The new income tax, based on Addington's model, was imposed on incomes above £150. Although this measure was initially intended to be temporary, it soon became a fixture of the British taxation system. A committee was formed in 1851 under Joseph Hume to investigate the matter, but failed to reach a clear recommendation. Despite the vociferous objection, William Gladstone, Chancellor of the Exchequer from 1852, kept the progressive income tax, and extended it to cover the costs of the Crimean War. By the 1860s, the progressive tax had become a grudgingly accepted element of the English fiscal system. [20]

In the United States, the first progressive income tax was established by the Revenue Act of 1862. The act was signed into law by President Abraham Lincoln, and replaced the Revenue Act of 1861, which had imposed a flat income tax of 3% on incomes above $800. The Sixteenth Amendment to the United States Constitution, adopted in 1913, permitted Congress to levy all income taxes without any apportionment requirement. By the mid-20th century, most countries had implemented some form of progressive income tax. [21]

Measuring progressivity

Indices such as the Suits index, [8] Gini coefficient, Kakwani index, Theil index, Atkinson index, and Hoover index have been created to measure the progressivity of taxation, using measures derived from income distribution and wealth distribution. [22]

Marginal and effective tax rates

German marginal and average income tax rates display a progressive structure. Income Tax Germany 2010.png
German marginal and average income tax rates display a progressive structure.

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 the amount subject to taxation rises, though there may be ranges where the marginal rate will be constant. Usually, the average tax rate of a tax payer will be lower than the marginal tax rate. In a system with refundable tax credits, or income-tested welfare benefits, it is possible for marginal rates to fall as income rises, at lower levels of income.[ citation needed ]

Inflation and tax brackets

Tax laws might not be accurately indexed to inflation. For example, some tax laws may ignore inflation completely. 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 rates. This phenomenon is known as bracket creep and can cause fiscal drag.[ citation needed ]

Economic effects

There is debate between politicians and economists over the role of tax policy in mitigating or exacerbating wealth inequality[ citation needed ] and the effects on economic growth [ citation needed ].

Income equality

Progressive taxation has a direct effect on reducing income inequality. [13] This is especially true if taxation is used to fund progressive government spending such as transfer payments and social safety nets. [12] However, the effect may be muted if the higher rates cause increased tax evasion. [13] [23] 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. [24] [25] High levels of income inequality can have negative effects on long-term economic growth, employment, and class conflict. [26] [27] Progressive taxation is often suggested as a way to mitigate the societal ills associated with higher income inequality. [12] 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. [28]

The economists Thomas Piketty and Emmanuel Saez wrote that decreased progressiveness in US tax policy in the post World War II era has increased income inequality by enabling the wealthy greater access to capital. [14]

According to economist Robert H. Frank, tax cuts for the wealthy are largely spent on positional goods such as larger houses and more expensive cars. Frank argues that these funds could instead pay for things like improving public education and conducting medical research, [29] and suggests progressive taxation as an instrument for attacking positional externalities. [30]

Economic growth

A report published by the OECD in 2008 presented empirical research showing a weak negative relationship between the progressivity of personal income taxes and economic growth. [15] Describing the research, William McBride, a staff writer with the conservative Tax Foundation, stated that progressivity of income taxes can undermine investment, risk-taking, entrepreneurship, and productivity because high-income earners tend to do much of the saving, investing, risk-taking, and high-productivity labor. [31] [32] According to IMF, some advanced economies could increase progressivity in taxation for tackling inequality, without hampering growth, as long as progressivity is not excessive. Fund also states that the average top income tax rate for OECD member countries fell from 62 percent in 1981 to 35 percent in 2015, and that in addition, tax systems are less progressive than indicated by the statutory rates, because wealthy individuals have more access to tax relief. [33]

Educational attainment

Economist Gary Becker has described educational attainment as the root of economic mobility. [34] Progressive tax rates, while raising taxes on high income, have the goal and corresponding effect of reducing the burden on low income, improving income equality. Educational attainment is often conditional on cost and family income, which for the poor, reduces their opportunity for educational attainment. [35] [36] Increases in income for the poor and economic equality reduces the inequality of educational attainment. [37] [38] Tax policy can also include progressive features that provide tax incentives for education, such as tax credits and tax exemptions for scholarships and grants. [39] [40]

A potentially adverse effect of progressive tax schedules is that they may reduce the incentives for educational attainment. [16] [36] [41] By reducing the after-tax income of highly educated workers, progressive taxes can reduce the incentives for citizens to attain education, thereby lowering the overall level of human capital in an economy. [16] [36] [41] However, this effect can be mitigated by an education subsidy funded by the progressive tax. [42] Theoretically, public support for government spending on higher education increases when taxation is progressive, especially when income distribution is unequal. [43]

Psychological factors

"Tax The Rich" banner at an International Union of Socialist Youth campaign for a financial transaction tax. IUSY2011 Banner Tax the Rich.JPG
"Tax The Rich" banner at an International Union of Socialist Youth campaign for a financial transaction tax.

A 2011 study psychologists Shigehiro Oishi, Ulrich Schimmack, and Ed Diener, using data from 54 countries, found that progressive taxation was positively associated with the subjective well-being, while overall tax rates and government spending were not. The authors added, "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." [17] Tax law professor Thomas D. Griffith, summarizing research on human happiness, has argued that because inequality in a society significantly reduces happiness, a progressive tax structure which redistributes income would increase welfare and happiness in a society. [44] Since progressive taxation reduces the income of high earners and is often used as a method to fund government social programs for low income earners, calls for increasing tax progressivity have sometimes been labeled as envy or class warfare, [30] [45] [46] while others may describe such actions as fair or a form of social justice. [46] [47]

Computation

The function which defines the progressive approach to an income tax, may be mathematically defined as a piecewise function. In every piece (tax bracket), it must be computed cumulatively, considering the taxes which had already been computed to the previous tax brackets. Pictured is the effective income tax for Portugal in 2012 and 2013. Taxa Real de IRS 2012-2013.svg
The function which defines the progressive approach to an income tax, may be mathematically defined as a piecewise function. In every piece (tax bracket), it must be computed cumulatively, considering the taxes which had already been computed to the previous tax brackets. Pictured is the effective income tax for Portugal in 2012 and 2013.

There are two common ways of computing a progressive tax, corresponding to point–slope form and slope–intercept form of the equation for the applicable bracket. These compute the tax either as the tax on the bottom amount of the bracket plus the tax on the marginal amount within the bracket; or the tax on the entire amount (at the marginal rate), minus the amount that this overstates tax on the bottom end of the bracket.

For example, suppose there are tax brackets of 10%, 20%, and 30%, where the 10% rate applies to income from $1 to $10,000; the 20% rate applies to income from $10,001 to $20,000; and the 30% rate applies to all income above $20,000. In that case the tax on $20,000 of income (computed by adding up tax in each bracket) is 10% × $10,000 + 20% × $10,000 = $1,000 + $2,000 = $3,000. The tax on $25,000 of income could then be computed two ways. Using point–slope form (tax on bottom amount plus tax on marginal amount) yields:

Geometrically, the line for tax on the top bracket passes through the point ($20,000, $3,000) and has a slope of 0.3 (30%).

Alternatively, 30% tax on $20,000 yields 30% × $20,000 = $6,000, which overstates tax on the bottom end of the top bracket by $6,000 − $3,000 = $3,000, so using slope–intercept form yields:

Geometrically, the line for tax on the top bracket intercepts the y-axis at −$3,000 – it passes through the point (0, −$3,000) – and has a slope of 0.3 (30%).

In the United States, the first form was used through 2003, for example (for the 2003 15% Single bracket): [48]

From 2004, this changed to the second form, for example (for the 2004 28% Single bracket): [49]

Examples

Distribution of US federal taxes from 1979 to 2013, based on CBO Estimates. Average US Federal Tax Rates 1979 to 2013.png
Distribution of US federal taxes from 1979 to 2013, based on CBO Estimates.

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 seven income tax brackets ranging from 10% to 39.6% above an untaxed level of income based on the personal exemption and usually various other tax exemptions, such as the Earned Income Tax Credit and home mortgage payments. The US federal tax system also includes deductions for state and local taxes for lower income households which mitigates what are sometimes regressive taxes, particularly property taxes. Higher income households are subject to the alternative minimum tax that limits deductions and sets a flat tax rate of 26% to 28% with the higher rate commencing at $175,000 in income. There are also deduction phaseouts starting at $112,500 for single filers. The net effect is increased progressivity that completely limits deductions for state and local taxes and certain other credits for individuals earning more than $306,300. [51]

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. [52] 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. [53]

See also

Contrasting models:

Related Research Articles

Tax Method to impose financial charge or other levy upon a taxpayer by a government or functional equivalent

A tax is a compulsory financial charge or some other type of levy imposed upon a taxpayer by a governmental organization in order to fund government spending and various public expenditures. A failure to pay, along with evasion of or resistance to taxation, is punishable by law. Taxes consist of direct or indirect taxes and may be paid in money or as its labour equivalent. The first known taxation took place in Ancient Egypt around 3000–2800 BC.

Supply-side economics is a macroeconomic theory arguing that economic growth can be most effectively created by lowering taxes and decreasing regulation, by which it is directly opposed to demand-side economics. According to supply-side economics, consumers will then benefit from a greater supply of goods and services at lower prices and employment will increase.

A regressive tax is a tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases. "Regressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from high to low, so that the average tax rate exceeds the marginal tax rate. In terms of individual income and wealth, a regressive tax imposes a greater burden on the poor than on the rich: there is an inverse relationship between the tax rate and the taxpayer's ability to pay, as measured by assets, consumption, or income. These taxes tend to reduce the tax burden of the people with a higher ability to pay, as they shift the relative burden increasingly to those with a lower ability to pay.

Economic inequality Divergence in economic well-being within a group

There are a wide variety of types of economic inequality, most notably measured using the distribution of income and the distribution of wealth. Besides economic inequality between countries or states, there are important types of economic inequality between different groups of people.

Tax brackets are the divisions at which tax rates change in a progressive tax system. Essentially, tax brackets are the cutoff values for taxable income—income past a certain point is taxed at a higher rate.

A wealth tax is a tax on an entity's holdings of assets. This includes the total value of personal assets, including cash, bank deposits, real estate, assets in insurance and pension plans, ownership of unincorporated businesses, financial securities, and personal trusts. Typically, liabilities are deducted from an individual's wealth, hence it is sometimes called a net wealth tax. This is in contrast to other tax plans such as an income tax, which is in use by countries like the United States. Wealth taxation plans are in use in many countries around the world and seek to reduce the accumulation of wealth by individuals.

A proportional tax is a tax imposed so that the tax rate is fixed, with no change as the taxable base amount increases or decreases. The amount of the tax is in proportion to the amount subject to taxation. "Proportional" describes a distribution effect on income or expenditure, referring to the way the rate remains consistent, where the marginal tax rate is equal to the average tax rate.

Income taxes in the United States are imposed by the federal, most states, and many local governments. The income taxes are determined by applying a tax rate, which may increase as income increases, to taxable income, which is the total income less allowable deductions. Income is broadly defined. Individuals and corporations are directly taxable, and estates and trusts may be taxable on undistributed income. Partnerships are not taxed, but their partners are taxed on their shares of partnership income. Residents and citizens are taxed on worldwide income, while nonresidents are taxed only on income within the jurisdiction. Several types of credits reduce tax, and some types of credits may exceed tax before credits. An alternative tax applies at the federal and some state levels.

Income tax in Australia is imposed by the federal government on the taxable income of individuals and corporations. State governments have not imposed income taxes since World War II. On individuals, income tax is levied at progressive rates, and at one of two rates for corporations. The income of partnerships and trusts is not taxed directly, but is taxed on its distribution to the partners or beneficiaries. Income tax is the most important source of revenue for government within the Australian taxation system. Income tax is collected on behalf of the federal government by the Australian Taxation Office.

In economics, the excess burden of taxation, also known as the deadweight cost or deadweight loss of taxation, is one of the economic losses that society suffers as the result of taxes or subsidies. Economic theory posits that distortions change the amount and type of economic behavior from that which would occur in a free market without the tax. Excess burdens can be measured using the average cost of funds or the marginal cost of funds (MCF). Excess burdens were first discussed by Adam Smith.

Optimal tax theory or the theory of optimal taxation is the study of designing and implementing a tax that maximises a social welfare function subject to economic constraints. The social welfare function used is typically a function of individuals' utilities, most commonly some form of utilitarian function, so the tax system is chosen to maximise the aggregate of individual utilities. Tax revenue is required to fund the provision of public goods and other government services, as well as for redistribution from rich to poor individuals. However, most taxes distort individual behavior, because the activity that is taxed becomes relatively less desirable; for instance, taxes on labour income reduce the incentive to work. The optimization problem involves minimizing the distortions caused by taxation, while achieving desired levels of redistribution and revenue. Some taxes are thought to be less distorting, such as lump-sum taxes and Pigouvian taxes, where the market consumption of a good is inefficient and a tax brings consumption closer to the efficient level.

The Robin Hood effect is an economic occurrence where income is redistributed so that economic inequality is reduced. The effect is named after Robin Hood, said to have stolen from the rich to give to the poor.

Income inequality in the United States National income inequality

Income inequality in the United States is the extent to which income is distributed in an uneven manner among the American population. It has fluctuated considerably since measurements began around 1915, moving in an arc between peaks in the 1920s and 2000s, with a 30-year period of relatively lower inequality between 1950–1980.

The history of taxation in the United States begins with the colonial protest against British taxation policy in the 1760s, leading to the American Revolution. The independent nation collected taxes on imports ("tariffs"), whiskey, and on glass windows. States and localities collected poll taxes on voters and property taxes on land and commercial buildings. In addition, there were the state and federal excise taxes. State and federal inheritance taxes began after 1900, while the states began collecting sales taxes in the 1930s. The United States imposed income taxes briefly during the Civil War and the 1890s. In 1913, the 16th Amendment was ratified, permanently legalizing an income tax.

A maximum wage, also often called a wage ceiling, is a legal limit on how much income an individual can earn. It is a prescribed limitation which can be used to affect change in an economic structure, but its effects are unrelated to those of minimum wage laws used currently by some states to enforce minimum earnings. A maximum wage does not directly redistribute wealth, but it does limit the nominal income of specific workers within a society.

Taxation in Norway is levied by the central government, the county municipality (fylkeskommune) and the municipality (kommune). In 2012 the total tax revenue was 42.2% of the gross domestic product (GDP). Many direct and indirect taxes exist. The most important taxes — in terms of revenue — are VAT, income tax in the petroleum sector, employers’ social security contributions and tax on "ordinary income" for persons. Most direct taxes are collected by the Norwegian Tax Administration (Skatteetaten) and most indirect taxes are collected by the Norwegian Customs and Excise Authorities.

Progressivity in United States income tax

In general, the United States federal income tax is progressive, as rates of tax generally increase as taxable income increases, at least with respect to individuals that earn wage income. As a group, the lowest earning workers, especially those with dependents, pay no income taxes and may actually receive a small subsidy from the federal government.

Tax policy and economic inequality in the United States discusses how tax policy affects the distribution of income and wealth in the United States. Income inequality can be measured before- and after-tax; this article focuses on the after-tax aspects. Income tax rates applied to various income levels and tax expenditures primarily drive how market results are redistributed to impact the after-tax inequality. After-tax inequality has risen in the United States markedly since 1980, following a more egalitarian period following World War II.

Causes of income inequality in the United States

Causes of income inequality in the United States describes the reasons for the unequal distribution of income in the US and the factors that cause it to change over time. This topic is subject to extensive ongoing research, media attention, and political interest.

Taxation in Brazil

The taxation system in Brazil is complex, with over sixty forms of tax. Historically, tax rates were low and evasion and avoidance were widespread. The 1988 Constitution called for an enhanced role of the State in society, requiring increased tax revenue. In 1960, and again between 1998 and 2004, efforts were made to make the collection system more efficient. Tax revenue gradually increased from 13.8% of GDP in 1947 to 37.4% in 2005. Tax revenue has become quite high by international standards, but without realising commensurate social benefit. More than half the total tax is in the regressive form of taxes on consumption.

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