Taxes can be differentiated by the effect they have on the allocation of income and wealth. A proportional tax is one that impinges the same relative liability on all the taxpayers—i.e., where tax liability and income move in equal levels. A progressive tax is recognisable by a more than proportional growth in the tax burden in relation to the growth in income, and a regressive tax is recognised by a less than proportional rise in the relative burden. Therefore, progressive taxes are viewed as fighting inequity in income distribution, while regressive taxes might increase these inequalities.

The taxes that are often regarded as progressive include individual income taxes and estate taxes. Income taxes that are nominally progressive, however, could become less so in the upper-income group—in particular if a taxpayer is permitted to reduce his tax base by nominating deductions or by removing certain income components from his taxable income. Proportional tax rates if applied to lower-income groups will also be more progressive if exemptions of a personal nature are declared.

Income measured over the period of a given year may not definitely give the most appropriate measure of taxpaying requirement. For example, transitory increases in income might be saved, and within temporary declines in income a taxpayer could select to finance consumption by decreasing savings. Therefore, if taxation is made comparable alongside “permanent income,” it would be less regressive (or more progressive) than when compared with annual income.

Sales taxes and excises (with the exception of luxuries) are generally regressive, because the portion of personal income consumed or spent on specific goods decreases as the rate of personal income increases. Poll taxes (also termed head taxes), levied as a fixed amount per capita, clearly are regressive.

It is not simple to determine corporate income taxes and taxes on business as progressive, regressive, or proportionate, because of uncertainty regarding the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of deciding who bears the tax burden rests essentially on whether a national or a subnational (that is, provincial or state) tax is being decided.

In regarding the economic purpose of taxation, it is relevant to differentiate between varied ideas of tax rates. The statutory rates are nominated in the legislation; usually these are marginal rates, but sometimes they are median rates. Marginal income tax rates indicate the fraction of incremental income demanded by taxation when income grows by one dollar. Ergo, if tax burden increases by 45 cents when income rises by one dollar, the marginal tax rate is 45 percent. Income tax regulations usually contain graduated marginal rates—i.e., rates that increase as income increases. Careful analysis of marginal tax rates are required to regard provisions in addition to the formal statutory rate structure. If, for example, a particular tax credit (reduction in tax) decreases by 20 cents for each one-dollar rise in income, the marginal rate is 20 percentage points more than specified in the statutory rates. Since marginal rates specify how after-tax income is changed in response to changes in before-tax income, they are the necessary ones for appraising incentive effects of taxation. It is even more difficult to nominate the marginal effective tax rate applied to income from business and capital, as it may be dependant on considerations 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 nil under a consumption-based tax.

Average income tax rates show the fraction of total income that is taken in taxation. The pattern of average rates is the one that is important for assessing 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 provided for the taxpayer and dependents and due to that marginal tax rates are graduated; on the flip side, preferential treatment of income received predominantly by high-income households can dampen these effects, producing regressivity, as indicated by average tax rates that decline as income rises.

For MYOB Brisbane expert advice, contact Stone Consulting today. Stone Consulting also runs MYOB training in Brisbane.