Taxes are categorized by the effect they have on the allocation of income and wealth. A proportional tax is the kind that impinges the same relative burden on each taxpayer – i.e., when tax liability and income move in the same levels. A progressive tax is recognisable by a higher than proportional growth in the tax burden relative to the rise in income, and a regressive tax is characterized by a less than proportional rise in the relative burden. Hence, progressive taxes are thought of as reducing a lack of equality in income distribution, but regressive taxes might cause an increase in these inequalities.
The taxes that are generally considered progressive include individual income taxes and estate taxes. Income taxes that are declarably progressive, however, might become less so within the upper-income demographic – especially if a taxpayer is allowed to lessen his tax base by nominating deductions or by taking some income elements from his taxable income. Proportional tax rates if applied to lower-income groups could also be more progressive if such exemptions of a personal nature are declared.
Income measured over a given period may not absolutely offer the most accurate measure of taxpaying ability. For example, transitory increases in income may be saved, and in temporary declines in income a taxpayer could select to pay for consumption by taking from savings. Therefore, if taxation is held in comparison with “permanent income,”it will be less regressive (or more progressive) than if it is held in comparison with annual income.
Sales taxes and excises (save luxuries) tend to be regressive, because the portion of own income consumed or spent for a specific good lowers as the amount of personal income grows. Poll taxes (also called head taxes), nominated as a standard amount per capita, clearly are regressive.
It is hard to determine corporate income taxes and taxes on business as progressive, regressive, or proportionate, because of a lack of certainty around the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of nominating who bears the tax burden lays crucially on whether a national or a subnational (that is, provincial or state) tax is being determined.
In considering the economic purposes of taxation, it is essential to differentiate between various points of tax rates. The statutory rates are those specified in law; generally these are marginal rates, but for some cases they are mean rates. Marginal income tax rates denote the fraction of incremental income taken by taxation when income is increased by one dollar. Therefore, if tax liability grows by 45 cents when income rises by one dollar, the marginal tax rate is 45 percent. Income tax laws usually contain graduated marginal rates – i.e., rates that rise as income increases. Careful analysis of marginal tax rates should consider provisions in addition to 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 higher than nominated in the statutory rates. Since marginal rates indicate how after-tax income moves in response to changes in before-tax income, they are the important ones for considering incentive effects of taxation. It is even more difficult to realise the marginal effective tax rate to apply to income from business and capital, as it may depend on such considerations 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 nil under a consumption-based tax.
Average income tax rates show the portion of total income that is required 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 increases with income.
Average income tax rates commonly grow with income, both because personal allowances are provided 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 shown by average tax rates that decline as income increases.
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