Taxes are distinguished by the impact they have on the allocation of income and wealth. A proportional tax is the kind that applies the same relative liability on each taxpayer—i.e., when tax liability and income increase in relative proportion. A progressive tax is recognised by a greater than proportional increase in the tax onus in relation to the increase in income, and a regressive tax is recognisable by a less than proportional increase in the relative burden. Therefore, progressive taxes are regarded as removing inequity in income distribution, while regressive taxes can have the result of increasing these inequalities.
The taxes that are normally thought to be progressive include individual income taxes and estate taxes. Income taxes that are initially progressive, however, may become less so within the upper-income demographic—in particular if a taxpayer is able to lessen his tax base by declaring deductions or by removing particular income aspects from his taxable income. Proportional tax rates which are applied to lower-income groups would also be more progressive if personal exemptions are made.
Income measured over the period of a given year might not necessarily offer the most appropriate measure of taxpaying requirements. For example, transitory increases in income may be saved, and in temporary declines in income a taxpayer might choose to finance consumption by reducing savings. Ergo, if taxation is made comparable along with “permanent income,” it would be less regressive (or more progressive) than if made comparable with annual income.
Sales taxes and excises (except luxuries) are usually regressive, because the portion of individual income consumed or spent on a specific good lowers as the level of personal income grows. Poll taxes (also called head taxes), calculated as a flat amount per capita, patently are regressive.
It is not easy to term corporate income taxes and taxes on business as progressive, regressive, or proportionate, because of the uncertainty about 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 effects of taxation, it is important to differentiate between several concepts of tax rates. The statutory rates will include those nominated in law; generally speaking these are marginal rates, but for some cases they are median rates. Marginal income tax rates signify the fraction of incremental income that is demanded by taxation when income is increased by one dollar. So, if tax burden rises by 45 cents when income increases by one dollar, the marginal tax rate is 45 percent. Income tax regulations often contain graduated marginal rates—i.e., rates that increase as income increases. Heavy analysis of marginal tax rates need to consider provisions other than the formal statutory rate structure. If, for example, a particular tax credit (reduction in tax) declines by 20 cents for each one-dollar increase in income, the marginal rate is 20 percentage points greater than indicated by the statutory rates. Since marginal rates signify how after-tax income changes in response to changes in before-tax income, they are the necessary ones for considering incentive effects of taxation. It is even more difficult to realise the marginal effective tax rate applied to income from business and capital, as it may be dependant on such factors as the structure of depreciation allowances, the deductibility of interest, and the provisions for inflation adjustment. A basic economic theorem holds that the marginal effective tax rate in income from capital is nil under a consumption-based tax.
Average income tax rates show the fraction of total income that is required in taxation. The pattern of average rates is the one that is necessary for considering the distributional equity of taxation. Under a progressive income tax the average income tax rate grows with income. Average income tax rates usually increase with income, both because personal allowances are allowed for the taxpayer and dependents and because marginal tax rates are graduated; on the other hand, preferential treatment of income received predominantly by high-income households could swamp these effects, forcing regressivity, as indicated by average tax rates that lessen as income increases.
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