Taxes can be categorized by the effect they have on the allocation of income and wealth. A proportional tax is the kind of tax that impinges the same relative burden on all taxpayers—i.e., in the case where tax liability and income move in relative levels. A progressive tax is recognisable by a higher than proportional increase in the tax liability in relation to the increase in income, and a regressive tax is recognised by a less than proportional rise in the comparable onus. Therefore, progressive taxes are regarded as reducing inequity in income distribution, while regressive taxes might result in increasing these inequalities.
The taxes that are normally regarded as progressive include individual income taxes and estate taxes. Income taxes that are nominally progressive, however, may become less so within the upper-income categories—in particular if a taxpayer is permitted to lessen his tax base by declaring deductions or by taking some certain income elements from his taxable income. Proportional tax rates if applied to lower-income categories will also be more progressive if such personal exemptions are claimed.
Income measured over the course of a given period may not absolutely offer the most suitable measure of taxpaying requirements. For example, transitory growth in income can be saved, and in temporary declines in income a taxpayer could opt to finance consumption by reducing savings. So, if taxation is regarded alongside “permanent income,” it can be less regressive (or more progressive) than when compared with annual income.
Sales taxes and excises (save on luxuries) are usually regressive, because the portion of individual income consumed or spent for a specific good declines as the amount of personal income rises. Poll taxes (also called head taxes), levied as a fixed amount per capita, obviously are regressive.
It is not easy to dictate corporate income taxes and taxes on business as progressive, regressive, or proportionate, due to the 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 rests crucially on whether a national or a subnational (that is, provincial or state) tax is being decided.
In considering the economic purposes of taxation, it is relevant to differentiate between various ideas of tax rates. The statutory rates will be nominated in the legislation; generally speaking these are marginal rates, but for some cases they are average rates. Marginal income tax rates indicate the fraction of incremental income demanded by taxation when income rises by one dollar. So, if tax onus rises by 45 cents when income rises by one dollar, the marginal tax rate is 45 percent. Income tax regulations commonly contain graduated marginal rates—i.e., rates that rise as income grows. Careful 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) reduces by 20 cents for each one-dollar growth in income, the marginal rate is 20 percentage points greater than nominated in the statutory rates. Since marginal rates indicate how after-tax income changes in response to changes in before-tax income, they are the relevant ones for regarding incentive effects of taxation. It is even more difficult to understand the marginal effective tax rate applied to income from business and capital, as 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 determines that the marginal effective tax rate in income from capital is nothing under a consumption-based tax.
Average income tax rates determine the part of total income that is taken in taxation. The pattern of average rates is the one that is necessary for assessing the distributional equity of taxation. Under a progressive income tax the average income tax rate increases with income. Average income tax rates usually increase with income, both because personal allowances are provided for the taxpayer and dependents and because marginal tax rates are graduated; on the flip side, preferential treatment of income received for the most part by high-income households may swamp these effects, producing regressivity, as displayed by average tax rates that lower as income rises.
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