Taxes can be differentiated by the effect they have on the distribution of income and wealth. A proportional tax is the kind that applies the same relative requirement on all the taxpayers—i.e., where tax liability and income grow in relative scale. A progressive tax is recognised by a higher than proportional growth in the tax burden in relation to the rise in income, and a regressive tax is recognisable by a less than proportional rise in the relative liability. Thus, progressive taxes are seen as removing the lack of equality in income distribution, whereas regressive taxes can have the result of increasing these inequalities.
The taxes that are usually considered progressive include individual income taxes and estate taxes. Income taxes that are categorically progressive, however, can become less so within the upper-income categories—especially if a taxpayer is allowed to lessen his tax base by claiming deductions or by taking some certain income components from his taxable income. Proportional tax rates if applied to lower-income categories can also be more progressive if such personal exemptions are claimed.
Income measured over the course of a given year may not absolutely come up with the most suitable measure of taxpaying requirement. For example, transitory increases in income might be saved, and in temporary declines in income a taxpayer may select to provide for consumption by taking from savings. So, if taxation is regarded alongside “permanent income,” it should be less regressive (or more progressive) than when it is held in comparison with annual income.
Sales taxes and excises (excepting luxuries) are generally regressive, because the share of personal income consumed or spent for specific goods lowers as the amount of personal income grows. Poll taxes (aka head taxes), calculated as a standard amount per capita, patently are regressive.
It is not simple to classify corporate income taxes and taxes on business as progressive, regressive, or proportionate, because of the uncertainty surrounding the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of determining who bears the tax burden depends crucially on whether a national or a subnational (that is, provincial or state) tax is being decided.
In assessing the economic effect of taxation, it is necessary to distinguish between various points of tax rates. The statutory rates include those dictated in law; often these are marginal rates, but occasionally they are median rates. Marginal income tax rates denote the fraction of incremental income that is demanded by taxation when income increases by one dollar. Hence, if tax onus rises by 45 cents when income rises by one dollar, the marginal tax rate is 45 percent. Income tax legislation often contain graduated marginal rates—i.e., rates that rise as income grows. Careful analysis of marginal tax rates need to take into account 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 rise in income, the marginal rate is 20 percentage points greater than specified by the statutory rates. Since marginal rates specify how after-tax income increases or decreases in response to changes in before-tax income, they are the important ones for considering incentive effects of taxation. It is even more complicated to know the marginal effective tax rate applied to income from business and capital, because it may be dependant on considerations such 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 nothing under a consumption-based tax.
Average income tax rates display the part of total income that is paid 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 rises with income. Average income tax rates usually grow with income, both because personal allowances are provided for the taxpayer and dependents and also because marginal tax rates are graduated; on the flip side, preferential treatment of income received predominantly by high-income households could dampen these effects, producing regressivity, as indicated by average tax rates that lessen as income rises.
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