Taxes are distinguished by the impact they have on the placement of income and wealth. A proportional tax is a kind that applies the same relative requirement on all taxpayers—i.e., where tax liability and income move in equal scale. A progressive tax is characterized by a higher than proportional rise in the tax burden in regard to the increase in income, and a regressive tax is recognisable by a less than proportional growth in the relative burden. Ergo, progressive taxes are thought of as reducing inequalities in income distribution, but regressive taxes are found to result in an increase these inequalities.
The taxes that are usually considered progressive include individual income taxes and estate taxes. Income taxes that are initially progressive, however, could become less so within the upper-income group—in particular if a taxpayer is able to lower his tax base by declaring deductions or by taking some particular income aspects from his taxable income. Proportional tax rates if applied to lower-income classes can also be more progressive if such personal exemptions are made.
Income measured over a given period does not absolutely offer the best measure of taxpaying requirements. For example, transitory increases in income could be saved, and within temporary declines in income a taxpayer might select to provide for consumption by taking from savings. Therefore, if taxation is held in comparison alongside “permanent income,” it should be less regressive (or more progressive) than when it is made comparable with annual income.
Sales taxes and excises (with the exception of those on luxuries) tend to be regressive, because the dissemination of individual income consumed or spent for a specific good lessens as the level of personal income grows. Poll taxes (aka head taxes), levied as a set amount per capita, clearly are regressive.
It is difficult to dictate corporate income taxes and taxes on business as progressive, regressive, or proportionate, because of the lack of certainty about the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of deciding who bears the tax burden rests for the most part on whether a national or a subnational (that is, provincial or state) tax is being determined.
In assessing the economic purpose of taxation, it is relevant to differentiate between various points of tax rates. The statutory rates are those nominated in the legislation; often these are marginal rates, but in some cases they are mean rates. Marginal income tax rates denote the fraction of incremental income that is demanded by taxation when income grows by one dollar. Hence, if tax liability rises by 45 cents when income increases by one dollar, the marginal tax rate is 45 percent. Income tax legislature generally contain graduated marginal rates—i.e., rates that grow as income grows. Careful analysis of marginal tax rates are required to regard provisions as well as the formal statutory rate structure. If, for example, a particular tax credit (reduction in tax) reduces by 20 cents for each one-dollar rise in income, the marginal rate is 20 percentage points more than nominated in the statutory rates. Since marginal rates signify how after-tax income moves in response to changes in before-tax income, they are the relevant ones for assessing incentive effects of taxation. It is even more complicated to nominate the marginal effective tax rate applicable to income from business and capital, because it may depend on considerations such as the structure of depreciation allowances, the deductibility of interest, and the provisions for inflation adjustment. A basic economic theorem holds that the marginal effective tax rate in income from capital is nothing under a consumption-based tax.
Average income tax rates determine the portion of total income that is required in taxation. The pattern of average rates is the one that is necessary for assessing the distributional equity of taxation. Under a progressive income tax the average income tax rate rises with income. Average income tax rates commonly grow with income, both because personal allowances are allowed for the taxpayer and dependents and also because marginal tax rates are graduated; on the other hand, preferential treatment of income received for the most part by high-income households could swamp these effects, allowing regressivity, as shown by average tax rates that decrease as income rises.
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