Progressive tax

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A progressive tax is a tax imposed so that the tax rate increases as the amount to which the rate is applied increases. The term "progressive tax" can be applied to any type of tax. It is frequently applied in reference to income taxes, where people with more disposable income pay a higher percentage of that income in tax than do those with less income. The term progressive refers to the way the rate progresses from low to high. The opposite of a progressive tax is a regressive tax, where the tax rate decreases as the amount to which the rate is applied increases. In between is a proportional tax, where the tax rate is fixed as the amount to which the rate is applied increases. Progressive taxes reduce the tax incidence of people with smaller incomes, as they shift the incidence disproportionately to those with higher incomes.

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[edit] Early proponents

The idea of a progressive income tax has garnered support from economists and political scientists of many different ideologies - ranging from Adam Smith, the founder of capitalist economics, to Karl Marx, the founder of communist economics. Many authorities trace the origin of modern progressive taxation to Adam Smith, who wrote in The Wealth of Nations:

The necessaries of life occasion the great expense of the poor. They find it difficult to get food, and the greater part of their little revenue is spent in getting it. The luxuries and vanities of life occasion the principal expense of the rich, and a magnificent house embellishes and sets off to the best advantage all the other luxuries and vanities which they possess. A tax upon house-rents, therefore, would in general fall heaviest upon the rich; and in this sort of inequality there would not, perhaps, be anything very unreasonable. It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion. [1]

A century later, Karl Marx argued for a progressive income tax in The Communist Manifesto: "In the most advanced countries the following will be pretty generally applicable:..a heavy progressive or graduated income tax."[2]

[edit] Reasons for implementation

Many of the arguments for progressive taxation are related to welfare economics

  • As income levels rise, levels of consumption tend to fall. Thus it is often argued that economic demand can be stimulated by reducing tax burden on lower incomes while raising the burden on higher incomes.
  • It is also argued that people with higher income tend to have a higher percentage of that in disposable income, and can thus afford a greater tax burden (this is the “vertical equity” argument). A person making exactly enough money to pay for food and housing cannot afford to pay any taxes without it causing material damage, while someone making twice as much can afford to pay up to half their income in taxes. A tax that actually took all income above some specified subsistence level would imply a marginal tax rate of 100%, a case to which the arguments against progressive taxation apply most strongly (see below).
  • If leisure is a superior good for very high earners, then the income effect may act as a disincentive to work. In this case, high marginal tax rates are critical to keep the most productive members of society working.
  • A progressive tax is an automatic stabilizer in the sense that if a person were to suffer a decrease in wages due to a recession then the money regained by being in a lower tax bracket lessens this blow.
  • It is inherent in tax policy that it implements economic and social policy. People who are concerned about a runaway, cancerous character in the global economy, greenhouse gases, etc., see benefits in progressive taxation, both in its braking effect on the economy and in helping shape economic activities towards necessities more effectively than purely monetary or fiscal policies.

[edit] Arguments against implementation

The classical argument against progressive taxation runs as follows:

The diminishing returns argument applies to the fraction of income used for present consumption. As income rises, diminishing returns implies that a smaller and smaller fraction of income will be spent on consumption goods. The remaining income will (of necessity) be used to purchase capital goods. This acts as a form of positive feedback that in turn yields more income for capital spending. Meanwhile (and because) these capital goods induce a decline in the costs of production which has the effect of raising real wages generally and implicitly raising the general standard of living. The income paid back on the capital helps create the disincentive to consume that creates capital spending. Thus, those capitalists who effectively manage their property are rewarded and given control of more (newly created) property, of which they are increasingly less inclined to consume and increasingly more inclined to purchase capital goods and thus further elevate the general standard of living by driving down the costs of production. As they acquire more capital goods, eventually their ownership outstrips their ability to manage and oversee what they own; however, they only control as many capital goods as can be attributed to the income of their prior capital---which previously did not exist. Therefore, their ownership does not negatively contribute to the general standard-of-living relative to counterfactual state of them not purchasing those goods. It would thus be misleading to argue that redistributing their capital may yield further increases in the standard-of-living. Doing so may well cause that effect, but doing so neglects that it was the assumption that redistribution would not happen that induced the accumulation of capital.

— Eugen von Böhm-Bawerk, Karl Marx and the Close of his System, 1896)

  • Progressive taxes lower savings rates. Thus, some argue against progressive taxation because they believe it shifts the total economic production of society away from capital investments (tools, infrastructure, training, research) and toward present consumption goods--this could happen because high-income earners tend to pay for capital goods (through investment activities) and low-income earners tend to purchase consumables. Smithian and neo-classical growth theory says that spending more on consumption goods and less on capital goods will slow the rise of the standard of living, and possibly even reduce it since capital goods increase future production possibilities.

To put this in neo-classical terms: high-earners have a lower marginal propensity to consume; so shifting the tax-burden away from them will increase the aggregate savings rate, which should increase steady state growth (if the savings rate is initially too low).

  • Progressive taxes create a work disincentive. Consider again someone who makes twice the minimum required to live on, but pays all income above the minimum living threshold in taxes. Such a person had no monetary incentive at all to try to increase his or her income above the base level[3]. It is presumed that the high-rate earner will therefore not work (because leisure gives higher utility). However, this assumption can be challenged in at least two ways: Firstly, the majority of top-rate tax payers are salary-earners, and have no freedom to set their own hours, and secondly, the assumption that they prefer leisure to work may not apply, in which case they may be as productive when their entire income is taken by the government as when it is not.

Another common argument is that progressive taxation acts as a disincentive to work. In comparing this assumption with the claim that progressive taxes work the other way, and encourage higher participation at the top end, econometric studies are inconclusive. It may be that there is no consistent aggregate effect either way, and that the incentive/disinctive argument for/against progressive taxation are weak.

    • Theoretically, there are two contrasting forces at work here. One is a substitution effect whereby work effort is decreased with higher tax rates as the relative gains from engaging in leisure (which is not taxed) increase. The other is an income effect whereby work effort is increased as the worker must work more hours to attain the same wage in the face of higher taxes. It is impossible to predict, a priori, which effect will dominate. The majority of econometric studies on the question suggest that, in aggregate, the two effects roughly cancel out.
  • Brain drain and tax avoidance. High progressive taxes may encourage emigration because taxes are not internationally harmonized, so very high earners are sometimes able to relocate in order to pay less tax, or find tax havens for their income. Unlike the opposing income effect and substitution effect of leisure which may make tax progressivity neutral in terms of working hours, the emigration rate can only increase with the top rates of tax.
    • The differential in the higher rates of tax between the United States and Europe are cited as a factor in the "brain drain" of high-earners to America in the 1960s, and is considered an important influence on modern "economic migration".
    • The increasing energy expended on tax avoidances which occur with greater progressivity produces an increase in the work of accountants and lawyers. Because tax avoidance creates no net wealth this work is unproductive, and can make taxes on the rich less efficient than on the middle class, who have less motivation to exploit tax loopholes.
  • Justice in representation. Economic equity is sometimes used to argue against progressive taxation, on the grounds of representation being out-of-proportion to taxation: While the top 5% in income in most countries pay over half the taxes[4] they only have 5% of the voting weight. This argument can be reversed into the plutocratic case that if tax is to be progressive it should be accompanied by greater say in elections for those who contribute most.
  • Politics of envy. The New York Times in June 2005 ran a high-profile campaign arguing that at the very-high incomes United States tax-payers actually face regressive taxation rates, equating income tax across wage and rental incomes. For instance, they project that if the Bush tax cuts are made permanent:
“By 2015, those making between $80,000 and $400,000 will pay as much as 13.9 percentage points more of their income in federal taxes than those making more than $400,000.” [5]

In response to this, Gregory Mankiw has written to the editor of the New York Times, arguing that wealth condensation is a cyclical phenomenon and that tax rates should not be adjusted to stabilize the share of income going to the top 0.1 percent of earners in boom years and depressions. He closes with another recurring argument against progressive taxes:

“If policy makers' primary goal is … economic prosperity for all, they should avoid focusing on the politics of envy.” [6]

[edit] Marginal and effective tax rates

Main articles: Marginal tax rate and Effective tax rate

The rate of tax can be expressed in two different ways, the marginal rate expressed as the rate on each additional piece of income (or last dollar spent) and the effective (average) rate expressed as the total tax paid divided by total income. In most progressive tax systems, both rates will rise as income rises, though there may be income ranges where the marginal rate will be constant. With a system of negative income tax, refundable tax credits, or income-tested welfare benefits, it is possible for marginal rates to fall as income rises: this can still be seen as progressive providing that the marginal rate is higher than the average rate at any particular level of income, since the average rate will rise as income rises; high marginal rates for those on low incomes can lead to a poverty trap within a progressive system, even if they face negative average rates.

[edit] Personal income tax brackets

[edit] United States

For more details on this topic, see Income tax in the United States and Taxation in the United States

The progressive aspects of the Federal income tax rates in the United States have varied widely since 1913. For example, in 1954 the Congress imposed a Federal income tax on individuals, with the tax imposed in layers of 24 income brackets at tax rates ranging from 20% to 91% (for a chart, see Internal Revenue Code of 1954). As of 2006, there are six "tax brackets" ranging from 10% to 35% used to calculate the percentage of taxable income (of individuals) that must be paid to the United States Treasury. If taxable income falls within a particular tax bracket, the individual pays the listed percentage of income on each dollar that falls within that monetary range. For example, a person who earned $10,000 in 2006 would be liable for 10% of each dollar earned from the 1st dollar to the 7,550th dollar, and then for 15% of each dollar earned from the 7,551st dollar to the 10,000th dollar, for a total of $1,122.50. This ensures that every rise in a person's salary results in an increase of after-tax salary. The Treasury Department in 2006 reported, based on IRS data, the share of all federal taxes paid by taxpayers of various income levels. The data shows the progressive structure of the U.S. federal tax system that reduces the tax incidence of people with smaller incomes, as they shift the incidence disproportionately to those with higher incomes - the top 0.1% of taxpayers by income pay 17.4% of all federal taxes (earning 9.1% of the income), the top 1% pay 36.9% (earning 19%), the top 5% pay 57.1% (earning 33.4%), and the bottom 50% pay 3.3% (earning 13.4%).[7]

[edit] New Zealand

For more details on this topic, see Taxation in New Zealand.

New Zealand has the following progressive income tax brackets (all values in New Zealand dollars with earner levy included): 19.5% up to $38,000, 33% from $38,001 to $60,000, 39% above $60,001, and 49% when the employee does not complete a declaration form (IR330).[8] In New Zealand, the income is taxed by the amount that falls within each tax bracket. In other words, if a person earns $60,000, they will only pay 33% on the amount that falls between $38,001 and $60,000 rather than paying this on the full $60,000.

[edit] Problems, alternatives, similar concepts

The tax bracket system has a few problems, however. Bracket creep occurs when the amounts are not tied to the cost of living; due to inflation tax rates would thus slowly rise.

An alternate system of having taxes with an increasing relative rate is a negative income tax, which eliminates the step problem.

Tax progressivity or regressivity should not be confused with two similar concepts: tax neutrality and tax incidence. Tax neutrality refers to whether similar things are taxed in similar ways; if for example taxes on gasoline and diesel are different then this will probably lead to a distortion in demand between the two fuels. If the tax system does not distort demand then it is said to be neutral. Tax incidence refers to what group ultimately bears the burden of a tax. For example, sales taxes, which are nominally applied to businesses, are passed through to consumers as higher prices - although the degree to which a sales tax is passed on to the consumer depends on elasticity, and one can measure the effective progressivity of a tax by income group as well as breaking the impact down by geographic area or other factors.

[edit] See also

[edit] Notes

  1. ^ Adam Smith, An Inquiry into the Nature And Causes of the Wealth of Nations (1776). Book Five: Of the Revenue of the Sovereign or Commonwealth. CHAPTER II: Of the Sources of the General or Public Revenue of the Society. ARTICLE I: Taxes upon the Rent of House. [1]
  2. ^ Marx, Karl. Section II. Proletarians and Communists. Communist Manifesto.
  3. ^ When the ‘optimal’ tax rates are derived in economic models it is almost always assumed that: (1) Increasing labour leads to increasing dis-utility, (2) the more ‘productive’ high-earners will make a choice between consumption and work that makes them at least as well off as lower-rate tax payers (a “self-selection constraint”). With these two assumptions, mathematical models maximizing various social ‘objectives’ can be designed but (excluding compulsion) all require some increase in consumption for higher-tax payers. For an example of this constraint in the most redistributive model (the Rawlsian model) see page 4 of: Optimal Income Taxation and the Ability Distribution: Implications for Migration Equilibria from Jonathan Hamilton and Pierre Pestieau (2002).
  4. ^ . Tax breakdown for the United States from the IRS which shows this pattern. The Economist magazine tends to rate the U.S. tax codes as being surprisingly progressive (below the levels of the super-rich) – perhaps because U.S. citizens rarely emigrate or move away from urban centres. However, in comparison to European social democratic countries, U.S. rates are certainly not unusually progressive, and many countries have any even greater proportional "disenfranchisement" of the rich.
  5. ^ Quote from the June 7, 2005 NYT editorial: “The Bush Economy” a series of articles on the subject of effectively falling tax rates for the “super-rich” were published by the Times in June 2005.
  6. ^ Quotation from the reply to the NYT claim of recessive taxation by professor N. Gregory Mankiw, the former chairman of President Bush's Council of Economic Advisers, (2003-2005).
  7. ^ Incomes and Politics, Wall Street Journal, September 02, 2006
  8. ^ The actual tax rates on the NZ Inland Revenue site (with examples).

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