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Progressive Tax
reference to income taxes, where people with more
income pay a higher percentage of it in terms of taxes. The term
progressive in itself, refers to the way the rate progresses from low to
high, but over time it has become confused with a modern or liberal
thought process.
Regressive tax is the opposite of a progressive tax and in this case, the amount of the tax is smaller as a percentage of income for people with larger incomes. Many other types of taxes other than the income tax tend to be regressive in practice: such as most sales taxes because persons with lower income spend a larger portion of their income; social security taxes since they exclude interest, and rent, dividends, capital appreciation and other kinds of income that are common for the affluent, and excise taxes.
As opposed to both these different systems of taxation, there also exists the flat tax system, also called a proportional tax, which is where one is charged a fixed tax rate based on the income group he is classified into and the rates are fixed, usually directly proportional to the income bracket.
Reasons Why Progressive Taxes should be Implemented
Most of the arguments for progressive taxation are related to welfare economics:
o In case the utility gained from income tends to exhibit diminishing marginal returns, as many psychologists assert, then for the tax burden to be shared in a utilitarian way, the tax-bill must not increase linearly with income.
o As income levels rise, the level of consumption tends to fall. Therefore it is often debated that economic demand can be stimulated by reducing tax burden on lower incomes while raising the burden on higher incomes.
o It is also argued that people with a higher income tend to have a higher percentage of that in disposable income, and can thus afford a greater tax burden; this is known as the vertical equity argument. It is easy to deduce 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 probably afford to pay up to half their income in taxes.
o In the example we have just seen, the marginal tax rate is effectively 100%, and hence there would be no monetary incentive at all for the first person to try to double his or her income. It is therefore presumed that the high-rate earner will not work because leisure gives a higher utility. However, this assumption can be challenged in two ways: First, 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 might prefer leisure to work need not apply, in which case they may be as productive when their entire income is taken by the government as when it is not.
o Societies such as those in Norway, and the United Kingdom have experimented with setting the top rate of earned income tax above the revenue-maximizing rate. This however was a political choice, presumably based on the principle that equality was more socially important than tax income or the GDP.
o Some believers of progressive taxation favor increasing taxes on the middle class tax-payers, who have inelastic household budgets.
o If leisure is a superior commodity for very high earners, then the income effect may act as a dampening agent in their spirit to work. In this case, the high marginal tax rates are critical to keep the most productive members of society working and contributing to the social cause.
o A progressive tax dons the role of 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 reduces the negative effect of an already reduces income.