Progressive tax
From Wikicpa
A progressive tax is a tax imposed so that the tax rate increases as the amount to which the rate is applied increases. The term "progressive tax" can be applied to any type of tax. It is frequently applied in reference to 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. Over time the term has also been associated with the concepts of modern or liberal.
The opposite of a progressive tax is a regressive tax, where the amount of the tax is smaller as a percentage of income for people with larger incomes than it is for those with lower incomes. Many taxes other than the income tax tend to be regressive, such as most sales taxes, since persons with lower income spend a larger portion of their income. Other examples of regressive taxes include social security taxes -- in part because they exclude interest, rent, dividends, capital appreciation and other kinds of income common for the affluent -- and statutory excise taxes.
A flat tax is a generic type of tax. When applied to income it is called a proportional tax, where the tax amount is fixed as a percentage of income. This term is generally used in the context of income taxes, although in the United States, Social Security taxes are a prime example of a flat tax, as it is fixed at 15% of income until a maximum income ceiling is reached. Above that ceiling, it becomes a regressive tax.
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Reasons to implement progressive tax
Many of the arguments for progressive taxation are related to welfare economics
- As income levels rise, levels of consumption tend to fall. Thus it is often argued that economic demand can be stimulated by reducing 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). 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. A tax that actually took all income above some specified subsistence level would imply a marginal tax rate of 100%, a case to which the arguments against progressive taxation apply most strongly (see below).
- Societies (such as Norway, and the United Kingdom) have occasionally set the top rate of earned income tax above the revenue-maximizing rate. This was a political choice, presumably based on the principle that equality was more socially important than tax income or GDP.
- Some supporters of progressive taxation favour increasing taxes on middle class tax-payers, who have income elasticity of demand.
- If leisure is a superior good for very high earners, then the income effect may act as a disincentive to work. In this case, high marginal tax rates are critical to keep the most productive members of society working.
- 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.
Arguments against implementation of a progressive tax
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)
- Progressive taxes lower savings rates. 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.
To put this in neo-classical terms: high-earners have a lower marginal 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 too low).
- Progressive taxes create a 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[4]. It is presumed that the high-rate earner will therefore not work (because leisure gives higher utility). However, this assumption can be challenged in at least two ways: Firstly, the majority of top-rate tax payers are salary-earners, and have no freedom to set their own hours, and secondly, the assumption that they prefer leisure to work may not apply, in which case they may be as productive when their entire income is taken by the government as when it is not.
Another common argument is that progressive taxation acts as a disincentive to work. In comparing this assumption with the claim that progressive taxes work the other way, and encourage higher participation at the top end, econometric studies are inconclusive. It may be that there is no consistent aggregate effect either way, and that the incentive/disinctive argument for/against progressive taxation are weak.
- Theoretically, there are two contrasting forces at work here. One is a substitution effect whereby work effort is decreased with higher tax rates as the relative gains from engaging in leisure (which is not taxed) increase. The other is an income effect whereby work effort is increased as the worker must work more hours to attain the same wage in the face of higher taxes. It is impossible to predict, a priori, which effect will dominate. The majority of econometric studies on the question suggest that, in aggregate, the two effects roughly cancel out.
- 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.
- 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[5] 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.
- Politics of envy. The New York Times in June 2005 ran a high-profile campaign arguing that at the very-high incomes United States tax-payers actually face regressive taxation rates, equating income tax across wage and rental incomes. For instance, they project that if the Bush tax cuts are made permanent:
“By 2015, those making between $80,000 and $400,000 will pay as much as 13.9 percentage points more of their income in federal taxes than those making more than $400,000.” [6]
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 (or the effective 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.
United States: History of changes in progressivity in Federal income tax
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%. Here is a partial history of changes in the U.S. Federal income tax rates for individuals (and the income brackets) since 1979:
| Year | Income brackets | Rate range |
|---|---|---|
| 1979 | 15 brackets | 14%-70% |
| 1982 | 12 brackets | 12%-50% |
| 1987 | 5 brackets | 11%-38.5% |
| 1988 | 3 brackets | 15%-33% |
| 1991 | 3 brackets | 15%-31% |
| 1993 | 5 brackets | 15%-39.6% |
| 2001 | 5 brackets | 15%-39.1% |
| 2002 | 6 brackets | 10%-38.6% |
| 2003-2005 | 6 brackets | 10%-35% |
Source: Internal Revenue Service
