A progressive tax
is a tax
imposed so that the tax rate
increases as the amount subject to taxation increases. In simple terms, it imposes a greater burden (relative to resources) on the rich than on the poor. "Progressive" describes a distribution effect on income
, 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 disproportionately to those with a higher ability-to-pay.
The term is frequently applied in reference to personal income taxes, where people with more disposable 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. The opposite of a progressive tax is a regressive tax, where the tax rate decreases as the amount subject to taxation increases. In between is a proportional tax, where the tax rate is fixed as the amount subject to taxation increases.
History of intellectual debate
The idea of a progressive tax has garnered support from 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 trace the origin of modern progressive taxation to Adam Smith, who wrote in The Wealth of Nations:
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 who realize that completely proportional taxation is not even a possibility. In the U.S., the vast majority of economists (81%) support progressive taxation.
Arguments for implementation
- In a free 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 purely economic realities, those who control great amounts of capital within a society, generally participate more directly in shaping government policy, often in ways that further maximize their wealth. Thus, it is a natural fact that the wealthiest in a society will, on average, become even disproportionately wealthier over time. It can be argued to avoid long term political instability a society must avoid this natural stratification toward an ever richer aristocracy or moneyed class, and an ever larger working class.
- 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 tend 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
- It is also 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 (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 it 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.
- A progressive tax is an automatic stabilizer in the sense that if a person were to suffer a decrease in wages due to a recession then the money regained by being in a lower tax bracket lessens this blow.
- It is inherent in tax policy that it implements economic and social policy. People who are concerned about a runaway, cancerous character in the global economy, greenhouse gases, etc., see benefits in progressive taxation, both in its braking effect on the economy and in helping shape economic activities towards necessities more effectively than purely monetary or fiscal policies.
- 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, 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
Arguments against progressive taxation tend to be found among libertarians
and some conservatives
. Among economists and social scientists, and to a lesser extent the general population, opponents of progressive taxation tend to be in the minority.
- Progressive taxes violate 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).
- 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 only control 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 can only increase with the top rates of tax.
- 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."
- Increase in 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.
- 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.
- 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.
- 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 only have 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)
- 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.
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
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. 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.
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 piece 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.
Base of taxation
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.
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
, 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 a income tax to a consumption tax would place an additional burden on the owners of existing assets, which would contribute to progressivity in the short run.
Most tax systems around the world contain progressive aspects. New Zealand
has the following progressive income tax brackets: 19.5% up to NZ$38
,000, 33% from $38,001 to $60,000, 39% above $60,001, and 49% when the employee does not complete a declaration form (IR330). Australia
has the following progressive income tax brackets: 0% effective up to AU$6000
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 six "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 US$10,000 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.