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Progressive tax

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A progressive tax is a tax imposed so that the effective tax rate increases as the economic well-being increases. While most often measured using single year income, economic well-being can also be measured by multi-year income, lifetime income, expenditure, or wealth (variations often depend on the tax base). The term "progressive tax" describes a distribution effect, and can be applied to individual taxes (for example, income or consumption), or to a tax system as a whole. It 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. The term progressive refers to the way the rate progresses from low to high. 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.

The term 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 tax on luxury goods and the exemption of basic necessities may be described as having progressive effects as it increases a tax burden on high end consumption and decreases a tax burden on low end consumption respectively. The opposite of a progressive tax is a regressive tax, where the effective tax rate decreases as the economic well-being increases. In between is a proportional tax, where the tax rate is fixed as the economic well-being increases. 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.

History of intellectual debate

The idea of a progressive income 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:

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.

A century later, Karl Marx argued for a progressive income tax in The Communist Manifesto: "In the most advanced countries the following will be pretty generally applicable: a heavy progressive or graduated income tax.

Reasons for implementation

In most western European countries and the United States, advocates of progressive taxation include the vast majority of economists and social scientists. In the U.S., the vast majority of economists (81%) support progressive taxation.

  • 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, levels of consumption tend to fall. 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 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 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.

  • Some supporters of progressive taxation favor increasing taxes on middle class tax-payers, who have inelastic household budgets.

  • 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 work. Indeed, for any particular income goal, the higher the tax rate, more work one must do to reach that income goal. For this reason, progressive income tax may increase the incentive to produce among the largest producers.

Arguments against implementation

Arguments against progressive taxation tend to come from libertarians and some conservatives. Among social scientists, and to a lesser extent the general population, opponents of progressive taxation tend to be in the minority.

  • 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)
    • Thus, some argue against progressive taxation because they believe it 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."
    • 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.

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 last dollar spent) and the effective (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. 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.

Measuring Progressivity

The progressivity of a tax can be expressed by its Suits index or the Gini Coefficient.

Personal income tax brackets

United States

The progressive aspects of the Federal income tax rates in the United States have varied widely since 1913. For example, in 1954 the Congress imposed a Federal income tax on individuals, with the tax imposed in layers of 24 income brackets at tax rates ranging from 20% to 91% (for a chart, see Internal Revenue Code of 1954). As of 2006, there are six "tax brackets" ranging from 10% to 35% used to calculate the percentage of taxable income (of individuals) that must be paid to the United States Treasury. 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 who earned $10,000 in taxable income (income after adjustments, deductions, and exemptions) for 2006 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. The Treasury Department in 2006 reported, based on Internal Revenue Service (IRS) data, the share of all federal taxes paid by taxpayers of various income levels. The data shows the progressive structure of the U.S. federal tax system that reduces the tax incidence of people with smaller incomes, as they shift the incidence disproportionately to those with higher incomes - the top 0.1% of taxpayers by income pay 17.4% of all federal taxes (earning 9.1% of the income), the top 1% pay 36.9% (earning 19%), the top 5% pay 57.1% (earning 33.4%), and the bottom 50% pay 3.3% (earning 13.4%).

However, if the federal taxation rate is compared with the wealth distribution rate, which was studied in A Rolling Tide: Changes in the Distribution of Wealth in the U.S. by Arthur Kennickell at Levy Economics Institute, the net wealth (not only income but also including real estate, cars, house, stocks, etc) distribution of the United States does almost coincide with the share of income tax - the top 1% pay 36.9% of federal tax (wealth 32.7%), the top 5% pay 57.1% (wealth 57.2%), top 10% pay 68% (wealth 69.8%), and the bottom 50% pay 3.3% (wealth 2.8%). Other taxes in the United States with a less progressive structure or a regressive structure, and legal tax avoidance loopholes change the overall tax burden distribution. For example, the payroll tax system is regressive on income with no standard deduction or personal exemptions taxing only the first $97,500 for 2007 from gross wages, and none earned from capital investments or interest. The Center on Budget and Policy Priorities states that three-fourths of U.S. taxpayers pay more in payroll taxes than they do in income taxes.

New Zealand

New Zealand has the following progressive income tax brackets (all values in New Zealand dollars with earner levy included): 19.5% up to $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). 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 33% on the amount that falls between $38,001 and $60,000 rather than paying this on the full $60,000.

Australia

Australia has the following progressive income tax brackets (all values are in Australian dollars): 0% up to $6000, 15% from $6001 to $25000, 30% from $25001 to $75000, 40% from $75001 to $150000, and 45% tax for any amount over $150000. These taxes are paid throughout Australia.

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.

See also

Notes

External links



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