Taxes are differentiated by the effect they have on the placement of income and wealth. A proportional tax is one that impinges the same relative liability on every taxpayer—i.e., when tax liability and income grow in the same scale. A progressive tax is recognisable by a larger than proportional increase in the tax onus in regard to the rise in income, and a regressive tax is recognisable by a less than proportional increase in the relative onus. Thus, progressive taxes are viewed as taking away inequalities in income distribution, while regressive taxes can increase these inequalities.
The taxes that are normally thought to be progressive include individual income taxes and estate taxes. Income taxes that are nominally progressive, however, could become less so in the upper-income class—particularly if a taxpayer is allowed to reduce his tax base by nominating deductions or by taking particular income elements from his taxable income. Proportional tax rates which are applied to lower-income classes will also be more progressive if such exemptions of a personal nature are made.
Income measured over the period of a year may not necessarily give the most suitable measure of taxpaying ability. For example, transitory rises in income may be saved, and during temporary declines in income a taxpayer could opt to finance consumption by taking from savings. Therefore, if taxation is held in comparison alongside “permanent income,” it would be less regressive (or more progressive) than when it is made comparable with annual income.
Sales taxes and excises (save on luxuries) are usually regressive, because the share of individual income consumed or spent on specific goods declines as the level of personal income is raised. Poll taxes (aka head taxes), levied as a standard amount per capita, patently are regressive.
It is hard to classify corporate income taxes and taxes on business as progressive, regressive, or proportionate, due to the lack of certainty surrounding the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of deciding who bears the tax burden rests essentially on whether a national or a subnational (that is, provincial or state) tax is being considered.
In assessing the economic purpose of taxation, it is necessary to differentiate between several points of tax rates. The statutory rates are specified in legislature; often these are marginal rates, but sometimes they are median rates. Marginal income tax rates denote the fraction of incremental income that is taken by taxation when income rises by one dollar. So, if tax onus increases by 45 cents when income grows by one dollar, the marginal tax rate is 45 percent. Income tax statutes usually contain graduated marginal rates—i.e., rates that grow as income increases. Structured analysis of marginal tax rates need to review provisions as well as 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 higher than specified by the statutory rates. Since marginal rates signify how after-tax income is changed in response to changes in before-tax income, they are the important ones for assessing incentive effects of taxation. It is even more difficult to nominate the marginal effective tax rate applicable to income from business and capital, since it may depend on considerations including the structure of depreciation allowances, the deductibility of interest, and the provisions for inflation adjustment. A basic economic theorem shows that the marginal effective tax rate in income from capital is nothing under a consumption-based tax.
Average income tax rates show the percentage of total income that is required in taxation. The pattern of average rates is the one that is in consideration for appraising the distributional equity of taxation. Under a progressive income tax the average income tax rate increases with income. Average income tax rates generally grow with income, both because personal allowances are permitted for the taxpayer and dependents and due to that marginal tax rates are graduated; conversely, preferential treatment of income received for the most part by high-income households could swamp these effects, forcing regressivity, as indicated by average tax rates that lower as income grows.
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