Progressive Tax

A system that collects a larger portion of taxes from high-income than low-income earners.

A progressive taxation system is a taxing system that collects a larger portion of taxes from high-income earners than from low-income earners. The idea of taxing progressively - that people of different income groups pay a different percentage of their income in taxes - stems from a concept called ability to pay.

The ability to pay is an idea that tries to ensure fairness in the domain of taxation. This idea supports the argument that individuals with various wealth levels or income levels should have to pay taxes at different rates.

Note the difference between wealth and income. Wealth includes many different physical and financial assets. The physical assets involve gold, real estate, cars, and like, while the financial assets include shares, bonds, and savings accounts.

How exactly do lower-income earners pay fewer taxes than high-income earners? What are the criteria? Progressive taxation is often implemented by using tax brackets.

Tax brackets aim at different grouping individuals with different incomes into appropriate groups. Each group will pay a certain percentage of their income in personal taxes. 

Most countries implement such taxing systems, including the US and much of Europe. US federal taxes for most ordinary income have 7 tax brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%.

Understanding the progressive tax system

It aims at reducing the burden of taxation on low-income earners. If both poor and rich people were required to pay the same amount of taxes regardless of income, then the effect on real purchasing power would be much more significant on the poorer people than the rich.

Some systems of taxing may be more progressive than others. It depends on the range of the brackets: the wider the range, the more progressive the taxing schedule. 

For example, a system with tax brackets ranging between 10% and 60% is more progressive than one with brackets ranging from 10% and 30%. That is because the first system collects a larger portion of taxes from the rich than the second.

It is important to note that such a taxing system does not tax a person's income under one bracket. It taxes at multiple rates as the income of the taxpayer increases. Different portions of a person's income are charged different tax rates.

Understanding tax brackets and marginal tax rates

Tax brackets are used in this systems. Tax brackets aim to charge different tax rates for a person's income range. This mechanism is based on the idea of marginal tax rates.

Marginal tax is the additional amount of tax that is paid for each additional dollar of income. Recall the important concept of marginalism, a core idea in economics. It refers to analyzing the additional or incremental costs or benefits of a choice or decision.

Under tax brackets, a person's income is divided into multiple ranges. Each portion is charged a different tax rate. The tax rate continuously increases with higher incomes. In other words, the marginal tax rate increases with increasing income.

The first portion or bracket of income is charged the lowest tax rate; the second portion is charged a relatively higher tax rate, and so on. As of 2022, income is divided into seven brackets in the United States, each being charged a gradually higher tax rate.

Note that the tax brackets differ for single filers than married (filing jointly or separately), widower, and head of household filers.

According to the IRS, the 2021-2022 income tax brackets are as follows:

Therefore, if your taxable income falls into more than one tax bracket, you will be charged multiple tax rates for each portion of your income. In contrast, if your taxable income only falls in the lowest bracket, you will only get charged the lowest tax rate, namely 10 percent.

Note that taxable income is the amount of income the government imposes a tax on. It is equal to total income minus exemptions minus deductions.

Understanding tax brackets and marginal tax rate
Taxable Income for Single FilersTaxable Income for Joint Married FilersMarginal Tax Rate
$0 to $10,275$0 to $20,55010%
$10,276 to $41,775$20,551 to $83,55012%
$41,776 to $89,075$83,551 to $178,15022%
$89,076 to $170,050$178,151 to $340,10024%
$170,051 to $215,950$340,101 to $431,90032%
$215,951 to $539,900$431,901 to $647,85035%
More than $539,901More than $647,85137%

Tax exemptions remove a portion of income to be taxed. Several entities can benefit from tax exemption, including:

  • Charitable organizations (non-profit organizations),
  • Veterans,
  • Certain businesses (exempted from property taxes).

On the other hand, tax deductions are also amounts of money deducted from total income. Total income may be deducted for several reasons, such as:

  • Mortgage and student loan interest,
  • Retirement plan contributions,
  • Charitable contributions,
  • Medical and dental expenses,
  • Gambling losses,
  • State and local taxes.

For example, the taxable income of a single person is calculated to be $79,700. This person's income overlaps multiple tax brackets, so the person will be charged different rates for each portion of the income.

Calculating the amount of tax requires multiple steps:

  1. The first $10,275 (the first bracket) will be taxed at a rate of 10%. This is equal to $1,028 of taxes.
  2. $10,276 to $41,775 (the second bracket) will be taxed at 12%. Therefore, $31,499 will be taxed at a rate of 12%. This is equal to $3,780 of taxes.
  3. $41,776 to $89,075 (the third and final bracket) will be taxed at a rate of 22%. Since total taxable income is $79,700, only $37,924 ($79,700 - $41,776) will be taxed at a rate of 22%. This is equal to $8,343 of taxes.
  4. Therefore, total taxes amount to: $1028 + $3,780 + $8,343 = $13,151. Total personal income taxes are equal to $13,151.

Calculating the Effective Tax Rate

The effective tax rate is the average tax rate imposed on the taxpayers. It is calculated by dividing the total amount of taxes by the total amount of taxable income.

Hence, the effective tax rate in our example is equal to: $13,151 ÷ $79,900 = 0.1646 = 16.46%.

Difference between progressive tax and regressive tax

Other than a progressive taxation system, there are multiple other systems that a country or an area can adopt. The other taxation systems of interest are regressive tax and proportional tax systems.

A regressive taxing system, by definition, is a system of taxation that collects a larger portion of taxes from low-income people than from high-income people. In regressive taxing systems, all taxpayers get charged the same amount. In other words, this tax is said to be uniformly applied.

At face value, this method may seem fair, as all eligible individuals pay the same amount of taxes. However, regressive taxation may be more hurtful for low-income people than for high-income people.

If two people pay the same dollar amount in taxes, the poorer person will suffer a greater fall in purchasing power than the higher-income person.

Therefore, regressive taxation is the polar opposite of a progressive taxing system. The latter aims to take a larger percentage of taxes from the rich while the former consumes a larger percentage of taxable income from the poor compared to the rich.

The most prominent examples of regressive taxes are:

  • Excise and sales taxes (taxes on the production and sale of goods),
  • User fees (taxes on using public services and facilities),
  • Property taxes (taxes on the value of the property),
  • Flat taxes (all levels of income are taxed at one rate with no tax brackets),
  • Sin taxes (taxes on products that can harm the individual or environment).

Difference between progressive tax and proportional tax

A proportional taxing system charges the same tax rate for all income levels. That is to say; both high and low-income earners pay the same percentage of their taxable income in taxes. 

This contrasts with progressive taxation, in which the tax rates increase with increasing income. That is the main difference between the two taxation systems.

Some areas and states in the US adopt a proportional taxing system, like Colorado, Indiana, Illinois, Massachusetts, Michigan, Pennsylvania, and Utah. 

Although it may not seem fair, proportional taxing can increase the incentive of residents to earn more without getting charged a higher tax rate.

In progressive taxing systems, there was a difference between marginal tax rates and average (or effective) tax rates. Proportional taxation, however, automatically makes both tax rates equal. That is because the marginal tax rate is the same for every additional dollar of taxable income earned.

Proportional taxes are also referred to as flat taxes. The idea of flat taxes was mentioned above in the regressive tax system. Proportional taxation is often regarded as regressive taxing because lower-income individuals tend to suffer more in terms of real purchasing power.

Progressive taxing: pros and cons

It charges a higher rate as taxable income increases. In other words, people who earn more pay more tax in such systems. 

The argument of whether this taxation schedule is good or not, or whether it is better than the other taxation mechanisms, depends on how it affects wealth inequality and economic growth. 

The most notable advantages of such taxing systems are the following:

  1. Transfers some of the financial burden from low-income to high-income individuals. In this way, the rich effectively pay a larger percentage of their incomes in taxes compared to the poor.
  2. Such taxing systems may reduce inequality among the citizens of a country regarding the quality of services provided. The poor may have the chance to escape the poverty trap through more refined public services like public education.
  3. Higher tax brackets that charge higher tax rates may increase tax revenue for the government. Compared to flat taxes, which charge a single tax rate, this taxation system usually collects more money in tax revenue.
  4. As a direct result of the additional tax revenue, the taxes from the rich may be put to good use in public projects, which greatly help the poor. Such projects include unemployment benefits and improved social security services.

Against the numerous upsides of implementing progressive taxation, this system has multiple drawbacks. Some of them include:

  1. This mechanism of taxation may create an incentive for rich people to work less. After all, much of what they earn is getting taxed and going to the government. This can mostly affect entrepreneurs, who can get discouraged by high marginal tax rates. Ultimately, this can place a draining burden on the economy.
  2. In countries that implement such taxation systems to extreme extents, rich people may opt to move their capital to other areas and countries where taxes are more favorable to them.
  3. A high number of brackets can be very costly for tax administration to conduct their work. In addition, more detailed brackets may also overcomplicate the procedure for tax filers, especially the ones that don't file their taxes with the help of a financial advisor.

History of the progressive taxing system

Progressive taxing schedules weren't around in the United States until the passing of the Revenue Act of 1861. This act was passed mainly to fund the civil war against the Confederacy. However, that act only imposed a flat tax of 3% on people who earned more than $800. 

It was in 1862 that tax brackets were formally introduced. The second Revenue Act of 1862 canceled the previous tax provision from 1961. The first progressive tax schedule replaced the proportional tax. 

This system charged 3% on people who earned between $600 and $10,000 and 5% on people who earned more than $10,000. The procedure differed between single filers, married (joint and separate), and head of household filers. 

This tax structure remained intact until 1872, until it was reinstated during the presidency of William Howard Taft in the 16th amendment of the US constitution. It stated:

"The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration."

The income tax imposed a rate of 1% on people with incomes between $1,000 and $20,000. The rate increases to 7% for people who earn more than $20,000.

The largest number of brackets implemented is 56 (in 1918), which charged marginal tax rates ranging from 6% to 77%.

After multiple changes, the most important of which is the Tax Reform Act of 1986 (which decreased tax rates and reduced the number of tax brackets to two), the US taxing schedule currently has seven tax brackets.

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Researched and Authored by Vatche Tchelderian | LinkedIn

Edited by Nicolas Palmer | LinkedIn

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