Taxes are categorized by the impact they have on the distribution of income and wealth. A proportional tax is a kind that places the same relative requirement on all taxpayers—i.e., when tax liability and income grow in the same proportion. A progressive tax is characterizable by a greater than proportional increase in the tax liability relative to the increase in income, and a regressive tax is recognised by a less than proportional rise in the relative burden. Hence, progressive taxes are seen as removing inequalities in income distribution, but regressive taxes are believed to increase these inequalities.
The taxes that are usually thought to be progressive include individual income taxes and estate taxes. Income taxes that are categorically progressive, however, may become less so in the upper-income demographic—particularly if a taxpayer is able to reduce his tax base by nominating deductions or by excluding some particular income elements from his taxable income. Proportional tax rates if applied to lower-income classes can also be more progressive if exemptions of a personal nature are declared.
Income measured over a given period may not definitely offer the most appropriate measure of taxpaying status. For example, transitory rises in income might be saved, and in temporary declines in income a taxpayer could decide to finance consumption by reducing savings. Thus, if taxation is held in comparison along with “permanent income,” it would be less regressive (or more progressive) than when held in comparison with annual income.
Sales taxes and excises (with the exception of luxuries) are mostly regressive, because the dissemination of own income consumed or spent for specific goods lessens as the amount of personal income increases. Poll taxes (also called head taxes), nominated as a set amount per capita, obviously are regressive.
It is difficult to classify corporate income taxes and taxes on business as progressive, regressive, or proportionate, principally because of the uncertainty regarding the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of dictating who bears the tax burden rests essentially on whether a national or a subnational (that is, provincial or state) tax is being debated.
In regarding the economic effect of taxation, it is essential to distinguish between various concepts of tax rates. The statutory rates are dictated in legislation; often these are marginal rates, but for some cases they are average rates. Marginal income tax rates note the fraction of incremental income taken by taxation when income rises by one dollar. Therefore, if tax liability increases by 45 cents when income rises by one dollar, the marginal tax rate is 45 percent. Income tax laws commonly contain graduated marginal rates—i.e., rates that grow as income grows. Careful analysis of marginal tax rates must review provisions in addition to the formal statutory rate structure. If, for example, a particular tax credit (reduction in tax) lessens by 20 cents for each one-dollar rise in income, the marginal rate is 20 percentage points higher than indicated in 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 regarding incentive effects of taxation. It is even more complicated to nominate the marginal effective tax rate applicable to income from business and capital, as it may be dependant on factors such as the structure of depreciation allowances, the deductibility of interest, and the provisions for inflation adjustment. A basic economic theorem grants that the marginal effective tax rate in income from capital is zero under a consumption-based tax.
Average income tax rates display the part of total income that is taken in taxation. The pattern of average rates is the one that is important for appraising the distributional equity of taxation. Under a progressive income tax the average income tax rate increases with income. Average income tax rates generally increase with income, both because personal allowances are permitted for the taxpayer and dependents and also due to that marginal tax rates are graduated; on the other side of things, preferential treatment of income received predominantly by high-income households might dampen these effects, producing regressivity, as shown by average tax rates that lessen as income rises.
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