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Progressive Tax System

Progressive Tax System

Do you like paying taxes? Generally, most people don't. However, they are an integral part of the economy! Not just the economy but the government can provide goods and services to its citizens by utilizing tax revenue. It's very important, even if it doesn't feel great to pay taxes! There are many ways for a government to tax its citizens: flat tax, regressive tax, progressive tax, VAT tax, etc. Want to learn more about why governments may utilize the progressive tax system over others? If so, continue reading!

Progressive Tax Example

Let's go over a progressive tax example. However, let's first define what a progressive tax system is. A progressive tax increases the tax rate as individuals increase their income.

A progressive tax increases the tax rate as individuals increase their income.

Simply put, in a progressive tax system, the more income you make, the more you pay in taxes. In contrast, the less income you make, the less you pay in taxes. This tax system is designed to be more equitable so that the tax burden is placed on those that can afford it.

Let's now look at an example of a progressive tax system.

It's time to pay taxes! Mark, Sally, and Rachel are all going to pay different amounts in taxes because of their income. Mark has an annual income of $50,000; Sally has an annual income of $80,000; Rachel has an annual income of $100,000. Mark will pay 5% in income taxes; Sally will pay 15% in income taxes; Rachel will pay 20% in income taxes. Since the tax rate increases as their incomes increase, then it is a progressive tax system.

Want to learn more about taxes? Check out these articles:

- Federal Taxes

- State and Local Tax

- Marginal Tax Rate

Advantages of a Progressive Tax System

What are the advantages of a progressive tax system? Generally, the main benefit of a progressive tax system is the equity that is involved in this type of system.1 We can take a deeper look into how equity is prominent in a progressive tax system.

First, let's define the two types of tax equity: horizontal equity and vertical equity. Horizontal equity states that people with the same ability to pay should pay the same amount in taxes.

Dive into the issues of equity in the tax system in our article - Tax Equity!

For example, if Rick and Bianca both make $70,000 a year, then they should pay the same amount in taxes.

Horizontal equity becomes difficult to implement when we think about other factors. What about if Rick had to pay a lot in hospital bills due to sickness? While Rick and Bianca still earn $70,000 a year, it doesn't seem as equitable anymore, given that Rick will be paying a lot more in hospital bills.

In contrast, vertical equity states that people with a higher ability to pay should be paying more in taxes. In other words, the more someone makes in income, the more they should pay in taxes. If this sounds familiar, it's because it is! Recall that a progressive tax system increases the tax rate as an individual's income increases. The more you make, the more you pay in taxes. If everyone paid the same amount in taxes despite varying levels of income, this would not be progressive. Let's see why.

If the tax rates were the same for everyone, it would impact higher-income individuals less than it would impact lower-income individuals. To see this, let's go over how the same tax rate for everyone is more beneficial to higher-income individuals.

For example, let's say there are two people who have to pay a 10% tax rate on their income — Mike and Sarah. Mike makes $60,000, and Sarah makes $150,000. A 10% tax rate for each person is going to affect their income differently. For example, Mike would pay $6,000 in taxes, whereas Sarah would pay $15,000 in taxes. While Sarah pays more in taxes, she is left with $135,000 post-tax, and Mike is left with $54,000 post-tax. At the same tax rate, Mark is impacted more than Sally is when we compare their post-tax earnings.

Progressive Tax System Tax on Consumers Graph StudySmarterFig. 1 - Tax on consumers

What does the diagram above tell us? The diagram shows what a tax on consumers would look like in the market. A tax on consumers would decrease demand for a particular good and shift demand to the left. Ptax – P1 is the tax amount that the government imposes on the consumer. The area shaded as "consumer burden" is the amount of tax that the consumer will pay, and the area "producer burden" is the amount that the producer will pay. When adding the consumer and producer burden together, we get the full value that the tax will generate!

Progressive Tax System Disadvantages

What are the disadvantages of a progressive tax system? The main disadvantage is that a progressive tax system may disincentivize people from working harder and innovating in the economy. Why might this be the case? Let's dig deeper!

In a progressive tax system, tax rates increase as a person's income increases. This is meant to shift the tax burden away from lower-income people since they will be hurt more by higher tax rates. However, this can have negative effects on those that do incur higher tax rates. Let's look at a brief example of what might happen in a progressive tax system.

Let's say that Marcus makes $90,000 a year and is close to getting a promotion at his job, which will help him earn $100,000 a year! This is phenomenal news, but there's one problem — Marcus doesn't want the promotion. The reason? Marcus lives in a country with a progressive tax system. If Marcus earns $100,000 a year, he will have to pay more in taxes than if he continues earning $90,000, and he does not want to pay more in taxes. Therefore, Marcus will not take the promotion in order to continue paying a lower tax rate.

The example above encapsulates the main disadvantage of a progressive tax system. While it may be more equitable for higher-income people to pay for higher tax rates, they may not feel altruistic enough to actually do it. Therefore, people may work less and innovate less to pay lower tax rates rather than earn more and innovate more and pay a higher tax rate.

Theory of Progressive Tax System

Let's go over the theory of the progressive tax system. Edwin R. A. Seligman states that the theory of a progressive tax system can be classified under two categories: socialistic and economic.2

The socialistic theories generally posit that it is the state's duty to address any inequities in the economy by altering its fiscal policy based on socioeconomic status. Seligman believes that this view is unrealistic for the government to achieve, and if it were a function of the government, "it would be useless to construct any science of finance."3

In contrast, economic theories look at the practical applications of a progressive tax system. For example, one would view how a progressive tax system would affect the general tax structure and its effects on state and local governments.

Progressive Tax vs. Regressive Tax

Let's discuss a progressive tax vs. a regressive tax. Recall that a progressive tax increases the tax rate as individuals increase their income. In contrast, a regressive tax lowers the tax rate as individuals increase their income.

A regressive tax lowers the tax rate as individuals increase their income.

The main difference between a progressive tax vs. a regressive tax system is clear. A progressive tax shifts the tax burden predominantly to higher-income individuals, whereas a regressive tax shifts the tax burden predominantly to middle-income individuals. However, what implications does each tax system have, respectively?

A progressive tax system is seen as more equitable for individuals. The people who are more likely to incur a higher tax rate are the ones who can afford it — higher-income individuals. In contrast, lower-income individuals are less able to pay higher taxes, so the burden is shifted away from them.

In regard to a regressive tax system, this is not the case. Since a regressive tax system affects lower-income people more than higher-income people, the implications are different. Specifically, the incentives in a regressive tax system are different from a progressive tax system. People are more incentivized to work harder and increase their income since the more they make, the less they will pay in taxes. This incentive is integral to a regressive tax system, given how the burden is shifted away from higher-income people.

Progressive Tax System Laffer Curve StudySmarterFig. 2 - Laffer Curve

The diagram above is known as the Laffer curve. The Laffer curve tells us the relationship between tax rate and tax revenue. As you can see, you cannot have a tax rate that is at either extreme — 0% or 100%. Having the tax rate be at either extreme would result in no tax revenue. However, having a tax rate that is somewhere in the middle is ideal and would generate the most tax revenue!

Of course, the "perfect" tax rate to generate the most tax revenue will differ from country to country. Some countries are more communalistic and open to higher tax rates, whereas others are individualistic and against any type of tax rate. Regardless, the main idea behind the Laffer curve is that a lower tax rate may actually generate more tax revenue than a higher tax rate!

Find out how in our article - The Laffer Curve.

Let's now take a look at a chart of what a progressive tax system might look like.

Progressive Tax System Bar Chart of Taxes Paid and Government Spending Received in the United States StudySmarterFig. 3 - Taxes Paid and Government Spending Received in the United States, 2012. Source: Tax Foundation4

The chart above shows the taxes paid and government spending received in the United States. Each percentile is shown on the X-axis, and the amount paid or received is shown on the Y-axis in dollars. As you can see, those in the lower percentiles consistently paid less in taxes and received more in government spending. Also noteworthy is how much the top 20% paid in taxes! This is a great indicator that the United States has a progressive tax system in its economy.

Progressive Tax System - Key takeaways

  • A progressive tax increases the tax rate as individuals increase their income.
  • A regressive tax lowers the tax rate as individuals increase their income.
  • An advantage of a progressive tax system is the equity that it produces.
  • A disadvantage of a progressive tax system is that it can disincentivize harder work and innovation.
  • The theory of a progressive tax can be classified under two categories: economic and socialistic.

References

  1. Christian E. Weller, The Benefits of Progressive Taxation in Economic Development, https://journals.sagepub.com/doi/abs/10.1177/0486613407305286?journalCode=rrpa
  2. Edwin R. A. Seligman, The Theory of Progressive Taxation, http://www.jstor.org/stable/2485590
  3. Edwin R. A. Seligman, The Theory of Progressive Taxation, http://www.jstor.org/stable/2485590
  4. Tax Foundation, Taxes Paid and Government Spending Received, https://taxfoundation.org/distribution-tax-and-spending-policies-united-states/

Frequently Asked Questions about Progressive Tax System

A progressive tax example is when the government increases the tax rate for higher-income people than lower-income people.

The features of a progressive tax system are higher rates for wealthier people, and more equity.

Progressive taxes may disincentivize people from working harder and innovating since the more they earn, the greater they will be taxed.

Two advantages of a progressive tax system are equity and ameliorating income/wealth inequality.

A progressive tax system is more equitable and can lower income/wealth inequality.

Final Progressive Tax System Quiz

Question

What do federal taxes do?

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Answer

Taxes provide revenue for the government so that it can provide public goods and services for its citizens.

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Question

What is a flat tax?

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Answer

A tax with a flat tax rate despite the income level.

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What is a progressive tax?

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Answer

A progress tax has a tax rate that increases as a person's income increases.

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What is a regressive tax?

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Answer

A regressive tax has a tax rate that decreases as a person's income increases.

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Question

What is a marginal tax rate?

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Answer

A marginal tax rate is the tax rate that taxpayers face for each additional amount of taxable income. 

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Question

True/False: In the US, individuals who earn a higher level of income face a higher marginal tax rate.

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Answer

True.

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Question

What is a corporate income tax?

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Answer

A tax on a corporation's income.

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Question

What is a payroll tax?

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Answer

a tax that is typically imposed on the employees of a company. 

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True or False: Corporate income tax is NOT a source of federal taxes.

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Answer

False.

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True or False: Federal taxes are collected by local governments.

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Answer

False.

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True or False: Federal tax revenue is used only for private businesses.

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Answer

False.

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Question

The United States' income tax is a ____ tax.

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Answer

progressive.

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Question

For a regressive tax, the more you make, the ______ you pay in taxes as a proportion of your income.

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Answer

less.

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True or False: For a flat tax, everyone is subject to the same tax rate regardless of income/profits.

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Answer

True.

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True or False: In the United States, payroll taxes help fund social security and medicare.

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Answer

True.

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Question

What is a proportional tax?

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Answer

A proportional tax rate is a fixed percentage charged to different tax bases. Such as a 10% flat rate.

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Question

What is a progressive tax rate?

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Answer

A progressive tax rate is a tax rate that charges a higher percentage to high income earners

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What is a regressive tax?

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Answer

A regressive tax rate is one that costs low income earners a higher percentage of their income than it does to high-income earners.

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What are the three ways tax rates are categorized?

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Answer

Progressive.

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What are the three general categories taxes fall into?

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Answer

Income.

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What is incidence of tax?

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Answer

The one who ends up bearing the burden or paying the tax.

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Question

Where does the incidence of property taxes on rental units fall?

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Answer

On Renters.

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Question

Under the United States marginal income tax rate system, does $40,000 of income get charged 1 or 2 tax rates?

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Answer

2.

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Under the United States marginal income tax rate system, 

$400,000,000 of income would get charged at how many different tax rates?

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Answer

7.

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In the United States, 2021 tax brackets are categorized by family status, select all that apply.

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Answer

Single.

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What is a tax deduction?

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A tax deduction lowers the amount of money that will be taxed.

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Tax deductions can be standard/automatic and itemized.

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Answer

True.

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Those looking to maximize efficiency should minimize their tax burden.

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Answer

True.

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Why are corporate income tax revenues so low?

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Answer

Many businesses have converted to "pass-through" businesses, subject to different tax laws.

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Does taxation hurt economic growth or help it?

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Answer

Hurt.

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Question

What are state and local taxes?

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State and local taxes are taxes imposed by a state, county, or municipality to raise revenue to fund public services such as education, trash collection, etc.

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State and local taxes, sometimes assisted by federal grants, fund services administered and regulated at ________ level. 

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Answer

the state 

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What is the most significant expenditure funded primarily by state and local taxes?

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Answer

The most significant expenditure funded primarily by state and local taxes is public education, which includes PK-12 public schools, community colleges, and public universities. 

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____ taxes fund hospital expenditures, road construction, and a strong majority of social welfare spending.

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Answer

State

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____ taxes are the majority funding for PK-12 public education, fire protection, and law enforcement.

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Answer

Local

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The tax burden across the United States is relatively similar; otherwise, individuals and businesses would be incentivized to move to different locations to enjoy lower taxes.   

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Answer

True

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Are taxes paid to local and state government deductible?

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Yes

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What are some of the taxes local governments impose?

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Local governments impose sales taxes, property taxes, income taxes, and various fees for services.

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Which cities are more likely to have higher sales taxes?

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Answer

Cities with faster growth rates and higher demands for new infrastructure are more likely to have higher sales taxes

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Why fast growing cities are likely to have higher taxes?

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To fund specific government projects, such as the construction of new roads or city facilities.

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What's the use of state and local taxes?

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State sales taxes, property taxes, and income taxes are used to fund state agencies

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Why does the spending by states vary?

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Spending by states varies based on how government services are broken down between state and local authorities. 

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State spending may also be necessary to provide government services in rural counties and cities with low-income tax bases, as their revenues may be insufficient to support schools and infrastructure.


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Answer

True

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Give an example of state taxes that local governments do not have.

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Answer

Fuel taxes

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Many states also have tax credits similar to those offered by the federal government, including an earned income tax credit meant to boost the income of low-wage earners.

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Answer

True

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Question

What is His Majesty's Revenue and Commons?

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Answer

The tax authority in the UK.

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What are the 3 main taxes paid in the UK?

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Answer

Income tax, National Insurance Contributions, and value-added tax.

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Question

If Freddy earns £51,000 per year, how much income tax will he have to pay?

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Answer

\( 51,000-12,570=38,430 \)

\( 38,430 \times 0.2=7,686 \)


Freddy will have to pay £7,686 in income tax.

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Question

What kind of system is it when as the taxpayer's income increases, their average tax rate increases?

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Answer

A progressive tax system.

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Question

True or False: The US has a progressive tax rate while the UK does not.

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Answer

False: They both have progressive tax rates.

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