Progressive tax

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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.

Contents

1 Early proponents of progressive taxation
2 Reasons to implement progressive tax
3 Arguments against implementation of a progressive tax
4 Marginal and average tax rates
5 Personal Income Tax Brackets

5.1 United States: History of changes in progressivity in Federal income tax
5.2 United States: Year 2005 income brackets and tax rates
5.3 United States: Example of a tax computation
5.4 New Zealand

6 Problems, alternatives, similar concepts
7 See also
8 Notes and references
9 External links

Early proponents of progressive taxation

The idea of a progressive income tax has garnered support from economists and political scientists of many different ideologies. Adam Smith alluded to progressive taxation in The Wealth of Nations. Smith argued that "the expense of defending the society, and that of supporting the dignity of the chief magistrate, are both laid out for the general benefit of the whole society. It is reasonable, therefore, that they should be defrayed by the general contribution of the whole society, all the different members contributing, as nearly as possible, in proportion to their respective abilities." As an example of this, Smith advocated a progressive tax upon modes of transportation, writing: "When the toll upon carriages of luxury, upon coaches, post-chaises, &c. is made somewhat higher in proportion to their weight, than upon carriages of necessary use, such as carts, waggons, &c. the indolence and vanity of the rich is made to contribute in a very easy manner to the relief of the poor, by rendering cheaper the transportation of heavy goods to all the different parts of the country."

Likewise, in 1811, Thomas Jefferson advocated tariffs on the ground that they constituted a form of progressive taxation: "We are all the more reconciled to the tax on importation, because it falls exclusively on the rich...In fact, the poor man in this country who uses nothing but what is made within his own farm or family, or within the United States, pays not a farthing of tax to the general government...the farmer will see his government supported, his children educated, and the face of his country made a paradise by the contributions of the rich alone..."

Later, Smith's opposite number, Karl Marx, also argued for a progressive 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 to implement progressive tax

Many of the arguments for progressive taxation are related to welfare economics

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 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 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.

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 levelWhen the ‘optimal’ tax rates are derived in economic models it is almost always assumed that: (1) Increasing labour leads to increasing dis-utility, (2) the more ‘productive’ high-earners will make a choice between consumption and work that makes them at least as well off as lower-rate tax payers (a “self-selection constraint”). With these two assumptions, mathematical models maximizing various social ‘objectives’ can be designed but (excluding compulsion) all require some increase in consumption for higher-tax payers. For an example of this constraint in the most redistributive model (the Rawlsian model) see page 4 of: [Optimal Income Taxation and the Ability Distribution: Implications for Migration Equilibria] from Jonathan Hamilton and Pierre Pestieau (2002).. 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. [Tax breakdown for the United States from the IRS] which shows this pattern. The Economist magazine tends to rate the U.S. tax codes as being surprisingly progressive (below the levels of the super-rich) – perhaps because U.S. citizens rarely emigrate or move away from urban centres. However, in comparison to European social democratic countries, U.S. rates are certainly not unusually progressive, and many countries have any even greater proportional "disenfranchisement" of the rich. 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.” Quote from the June 7 2005 NYT editorial: [“The Bush Economy”] a series of articles on the subject of effectively falling tax rates for the “super-rich” were published by the Times in June 2005.

In response to this, Gregory Mankiw has written to the editor of the New York Times, 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.” Quotation from the reply to the NYT claim of recessive taxation by professor N. Gregory Mankiw, the former chairman of President Bush's Council of Economic Advisers, (2003-2005).

Opponents counter that greed, such as they see as the primary motivation behind the tax cuts for the wealthy supported by Mankiw, is documented as being far more harmful to society than the sort of envy which might motivate the poor and middle class to support progressive taxation, because, for example, greed is almost always implicated in large-scale financial crimes (e.g. corporate tax evasion), while envy is rarely if ever the motivation for large-scale crime.

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.

Personal Income Tax Brackets

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% (for a chart, see Internal Revenue Code of 1954). 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%

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, Instructions for Form 1040 (for each year listed)

United States: Year 2005 income brackets and tax rates

As of 2005 there are six "tax brackets" used to calculate the percentage of taxable income (of individuals) that must be paid to the United States Treasury. For the unmarried, these percentages are:

Income from $1 to $7,300, tax bracket is 10%

Income from $7,301 to $29,700, tax bracket is 15%

Income from $29,701 to $71,950, tax bracket is 25%

Income from $71,951 to $150,150, tax bracket is 28%

Income from $150,151 to $326,450, tax bracket is 33%

Income $326,451 and above, tax bracket is 35%

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 1st dollar to the 7,300th dollar, and then for 15% of each dollar earned from the 7,301st dollar to the 10,000th dollar, for a total of $1,135. This ensures that every rise in a person's salary results in an increase of after-tax salary.

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). That is, because the marginal tax rate is always far less than 100%, an individual is financially "better off" realizing "more" income than "less" income, even though the marginal tax rate applicable to the highest level of income of that person increases as income increases.

United States: Example of a tax computation

Income tax:

$30,000 (gross income)
$7,300 * 0.10 = $730
($29,700 - $7,300) * 0.15 = $3,360
($30,000 - $29,700) * 0.25 = $75
Total income tax = $4,165 (13.88% of income)

FICA (payroll) tax (note that an equal amount is paid by the employer):

$30,000 (gross income)
$30,000 * 0.062 = $1,860 (Social Security portion)
$30,000 * 0.0145 = $435 (Medicare portion)
Total FICA tax = $2,295 (7.65% of income)

Total federal tax = $6,460 (21.53% of income)

New Zealand

New Zealand has the following income tax brackets (as of May 2005). All values in New Zealand dollars. (With earner levy included[The actual tax rates on the NZ Inland Revenue site] (with examples).):

19.5% up to $38,000
33% from $38,001 to $60,000
39% above $60,001
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 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 to 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.

Notes and references

External links

[Revised 2003 Tax Rate Schedules]
[Income Tax Rates for Individuals - New Zealand]
[What's Wrong with the Progressive Income Tax]
http://www.monbiot.com/archives/2005/01/11/punitive-and-it-works/ A Guardian article by George Monbiot, on the Swedish tax system. It focuses on it's positive effect to the country’s economic competitiveness, while at the same time reducing inequality. The article cites sources such as the United Nations Development Programme; Human Development Report 2004, the U.S. Department of Labor Bureau of Labor Statistics (1960-1998), The Economist, 2004. Pocket World in Figures, 2005 edition and the Institute of Social Analysis http://www.columbia.edu/~sr793/papers.html.

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