Taxes can be differentiated by the effect they have on the distribution of income and wealth. A proportional tax is one that places the same relative burden on each taxpayer—i.e., in the case where tax liability and income grow in equal proportion. A progressive tax is characterized by a more than proportional increase in the tax burden relative to the increase in income, and a regressive tax is recognised by a less than proportional rise in the relative liability. Ergo, progressive taxes are regarded as removing the lack of equality in income distribution, but regressive taxes might result in increasing these inequalities.
The taxes that are usually thought to be progressive include individual income taxes and estate taxes. Income taxes that are declarably progressive, however, might become less so for the upper-income demographic—in particular if a taxpayer is allowed to lessen his tax base by claiming deductions or by leaving out particular income elements from his taxable income. Proportional tax rates when applied to lower-income classes would also be more progressive if personal exemptions are claimed.
Income measured over the course of a given period might not definitely provide the best measure of taxpaying requirement. For example, transitory increases in income may be saved, and in temporary declines in income a taxpayer could select to provide for consumption by decreasing savings. Therefore, if taxation is compared with “permanent income,” it should be less regressive (or more progressive) than when compared with annual income.
Sales taxes and excises (except those on luxuries) tend to be regressive, because the share of one’s income consumed or spent on a specific good lowers as the rate of personal income grows. Poll taxes (also called head taxes), nominated as a set amount per capita, clearly are regressive.
It is not easy to dictate corporate income taxes and taxes on business as progressive, regressive, or proportionate, due to uncertainty regarding the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of deciding who bears the tax burden lays crucially on whether a national or a subnational (that is, provincial or state) tax is being debated.
In analysing the economic purpose of taxation, it is essential to distinguish between several concepts of tax rates. The statutory rates will include those dictated in legislation; generally these are marginal rates, but occasionally they are mean rates. Marginal income tax rates denote the fraction of incremental income taken by taxation when income rises by one dollar. So, if tax burden rises by 45 cents when income grows by one dollar, the marginal tax rate is 45 percent. Income tax legislation usually contain graduated marginal rates—i.e., rates that increase as income grows. Careful analysis of marginal tax rates are required to regard provisions in addition to the formal statutory rate structure. If, for example, a particular tax credit (reduction in tax) declines by 20 cents for each one-dollar rise in income, the marginal rate is 20 percentage points greater than indicated in the statutory rates. Since marginal rates display how after-tax income is changed 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, since it may be dependant on considerations including 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 nil under a consumption-based tax.
Average income tax rates indicate the fraction of total income that is taken in taxation. The pattern of average rates is the one that is important for judging the distributional equity of taxation. Under a progressive income tax the average income tax rate rises with income. Average income tax rates usually rise 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 can dwarf these effects, allowing regressivity, as indicated by average tax rates that lessen as income rises.
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