Taxes are categorized by the impact they have on the distribution of income and wealth. A proportional tax is one that impinges the same relative onus on all taxpayers—i.e., where tax liability and income increase in the same scale. A progressive tax is characterizable by a higher than proportional increase in the tax onus in relation to the growth in income, and a regressive tax is characterized by a less than proportional growth in the relative onus. Thus, progressive taxes are thought of as reducing the lack of equality in income distribution, but regressive taxes might increase these inequalities.
The taxes that are often considered progressive include individual income taxes and estate taxes. Income taxes that are categorically progressive, however, might become less so for the upper-income group—especially if a taxpayer is permitted to reduce his tax base by claiming deductions or by leaving out some particular income parts from his taxable income. Proportional tax rates when applied to lower-income demographics will also be more progressive if such personal exemptions are claimed.
Income measured over a given year might not necessarily provide the best measure of taxpaying ability. For example, transitory growth in income might be saved, and in temporary declines in income a taxpayer might select to finance consumption by decreasing savings. Therefore, if taxation is held in comparison alongside “permanent income,” it should be less regressive (or more progressive) than if held in comparison with annual income.
Sales taxes and excises (excepting those on luxuries) are mostly regressive, because the dissemination of one’s income consumed or spent for a specific good lessens as the amount of personal income increases. Poll taxes (also termed head taxes), calculated as a set amount per capita, patently are regressive.
It is complicated to classify corporate income taxes and taxes on business as progressive, regressive, or proportionate, principally because of the uncertainty around the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of deciding who bears the tax burden is dependant crucially on whether a national or a subnational (that is, provincial or state) tax is being decided.
In considering the economic effect of taxation, it is important to differentiate between differing ideas of tax rates. The statutory rates include those specified in law; commonly these are marginal rates, but for some cases they are average rates. Marginal income tax rates denote the fraction of incremental income taken by taxation when income increases by one dollar. Thus, if tax liability increases by 45 cents when income grows by one dollar, the marginal tax rate is 45 percent. Income tax legislature often contain graduated marginal rates—i.e., rates that rise as income rises. Structured analysis of marginal tax rates should take into account provisions other than the formal statutory rate structure. If, for example, a particular tax credit (reduction in tax) lowers by 20 cents for each one-dollar increase in income, the marginal rate is 20 percentage points greater than specified in the statutory rates. Since marginal rates indicate how after-tax income increases or decreases in response to changes in before-tax income, they are the relevant ones for appraising incentive effects of taxation. It is even more difficult to realise the marginal effective tax rate to apply to income from business and capital, as it may be reliant on such considerations as the structure of depreciation allowances, the deductibility of interest, and the provisions for inflation adjustment. A basic economic theorem determines that the marginal effective tax rate in income from capital is zero under a consumption-based tax.
Average income tax rates indicate the portion of total income that is taken in taxation. The pattern of average rates is the one that is relevant for considering the distributional equity of taxation. Under a progressive income tax the average income tax rate increases with income. Average income tax rates commonly rise with income, both because personal allowances are granted for the taxpayer and dependents and due to that marginal tax rates are graduated; on the other hand, preferential treatment of income received predominantly by high-income households may swamp these effects, allowing regressivity, as indicated by average tax rates that decline as income increases.
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