Progressive tax

A progressive tax, or graduated tax, is a tax that is larger as a percentage of income for those with larger incomes. It is usually applied in reference to income taxes, where people with more income pay a higher percentage of it in taxes. The term progressive refers to the way the rate progresses from low to high, but over time it has become confused with modern.

The opposite of a progressive tax is a regressive tax. In this case, the amount of the tax is smaller as a percentage of income for people with larger incomes. Many taxes other than the income tax tend to be regressive in practice: e.g. most sales taxes (since lower income people spend a larger portion of their income), social security taxes (because they exclude interest, rent, and other kinds of income common for the affluent), excise taxes, and so on. (A flat tax, also called a proportional tax, is one where the tax amount is fixed as a function of income, and is a term mainly used only in the context of income taxes.)

Arguments for

There are two main welfare economics arguments for a progressive tax system:

• First, 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.
• Second, it is 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.

Other arguments:

• In the example above, the marginal tax rate is effectively 100%, and therefore there would be no monetary incentive at all for the first person to try to double his or her incomeTemplate:Mn. 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.
• Societies (such as Norway, and the U.K.) 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 inelastic household budgets.
• 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.

Arguments against

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 turns 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

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 lesiure (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 U.S. and Europe are cited as a factor in the "brain drain" of high-earners to American 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 in 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 taxesTemplate:Mn 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 has recently (June 2005) run a high-profile campaign arguing that at the very-high incomes U.S. 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” Template:Mn

In response to this, Gregory Mankiw has written to the editor, arguing that wealth condensation is a cyclical phenomenon and that tax rates should not be adjusted to stabilize the share of income going to the top 0.1 percent of earners in boom years and depressions. He closes with another recurring argument against progressive taxes:

“ If policy makers' primary goal is … economic prosperity for all, they should avoid focusing on the politics of envy.” Template:Mn

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 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.

Personal Income Tax Brackets

United States

For example, in the United States as of 2004 there are six "tax brackets" that are used to calculate the percentage of taxable income that must be paid to the United States Treasury. For the unmarried, these percentages in 2003 and 2004 are:

• 10%: $2,651 - $9,700
• 15%: $9,701 - $30,800
• 25%: $30,801 - $68,500
• 28%: $68,501 - $148,700
• 33%: $148,701 - $321,200
• 35%: $321,201 and up

If an individual's 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 2003 would be liable for 10% of each dollar earned from the 2,651st dollar to the 9,700th dollar, and then for 15% of each dollar earned from the 9,701st dollar to the 10,000th dollar, for a total of $749.75. This ensures that every rise in a person's salary results in an increase of after-tax salary. As such, contrary to a popular belief, there is no point at which one is better off earning less money (or giving to charity to obtain deductions).

Example

An annual after tax income of $27,000 results in a tax cost of

• 30,800 (gross income)
• (9,700-2,651)*0.1=704.9 (bracket 1)
• (30,800-9,701)*0.15=3,164.85 (bracket 2)
• 704.9+3,164.85=3,869.75 (income tax excluding social security tax)
• 30,800*0.12=3,696 (social security tax)
• 3,869.75+3,696=7,565.75 (tax on income including social security tax)
• 30,800-3,869.75=26,930.25 (after tax income)

$7,566 (28% of after tax income) (includes "social security" of 12%, income tax of 13%).

Sweden

Sweden has three income tax brackets (2004) ($1 as 7 kronor):Template:Mn

• 31% (federal and state tax) + 200 kronor: 0 - 291,800 kronor ($0 - $41,700)
• 31% + 20% (federal tax) + 200 kronor: 291,800 - 441,300 kronor ($41,700 - $63,000)
• 31% + 25% (federal tax) + 28,280 kronor: 441,300 and up ($63,000 -)

Income tax is paid on the amount that falls within each bracket, to ensure that each increase in gross income is accompanied by an increase in net income.

Example

An annual after tax income of 190,000 kronor ($27,000) results in a tax cost of

• 500,000 (gross income)
• (291,800*.031 + 200) + ((441,300-291,800)*0.51 + 200) + ((500,000-441,300)*0.56 + 28,280) = 228,255 (income tax excluding social security tax)
• 500,000*0.33 = 165,000 (social security tax)
• 228,255+165,000 = 393,255 (tax on income (income tax and social security tax))
• 500,000-228,255 = 271,745 (after-tax income, not including social security tax)

393,255 kronor (145% of after-tax income) (includes "social security" of 33%, effective income tax of 46%).

New Zealand

New Zealand has the following income tax brackets (as of May 2005). All values in New Zealand dollars. (With earner levy includedTemplate:Mn):

• 20.7% up to $38,000
• 34.2% from $38,001 to $60,000
• 40.2% above $60,001
• 46.2% 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 34.2% on the amount that falls between $38,001 and $60,000 rather than paying this on the full $60,000.

Problems, alternatives, similar concepts

The tax bracket system has a few problems, however. Bracket creep occurs when the amounts are not tied to the cost of living, due to inflation tax rates would thus slowly rise.

An alternate system of having taxes with an increasing relative rate is a negative income tax, which eliminates the step problem.

Tax progressivity or regressivity should not be confused with two similar concepts: tax neutrality and tax incidence. Tax neutrality refers to whether similar things are taxed in similar ways; if for example taxes on gasoline and diesel are different then this will probably lead to a distortion in demand between the two fuels. If the tax system does not distort demand then it is said to be neutral. Tax incidence refers what group ultimately bears the burden of a tax. For example, sales taxes, which are nominally applied to businesses, are passed through to consumers as higher prices - although the degree to which a sales tax is passed on to the consumer depends on elasticity, and one can measure the effective progressivity of a tax by income group as well as breaking the impact down by geographic area or other factors.

See also

• Income tax
• Laffer curve
• Elasticity

External links

• Revised 2003 Tax Rate Schedules (http://www.irs.gov/formspubs/article/0,,id=109877,00.html)
• Income Tax Rates for Individuals - New Zealand (http://www.ird.govt.nz/income-tax-individual/itaxsalaryandwage-incometaxrates.html)

Notes