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 System Progressive Tax System

Create learning materials about Progressive Tax System with our free learning app!

  • Instand access to millions of learning materials
  • Flashcards, notes, mock-exams and more
  • Everything you need to ace your exams
Create a free account
Table of contents

    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

    What are progressive tax examples?

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

    What are the features of progressive taxes?

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

    How does progressive taxes affect the economy of a nation?

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

    What are two advantages of a progressive tax system?

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

    Why have a progressive tax system?

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

    Test your knowledge with multiple choice flashcards

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

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

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

    Next
    1
    About StudySmarter

    StudySmarter is a globally recognized educational technology company, offering a holistic learning platform designed for students of all ages and educational levels. Our platform provides learning support for a wide range of subjects, including STEM, Social Sciences, and Languages and also helps students to successfully master various tests and exams worldwide, such as GCSE, A Level, SAT, ACT, Abitur, and more. We offer an extensive library of learning materials, including interactive flashcards, comprehensive textbook solutions, and detailed explanations. The cutting-edge technology and tools we provide help students create their own learning materials. StudySmarter’s content is not only expert-verified but also regularly updated to ensure accuracy and relevance.

    Learn more
    StudySmarter Editorial Team

    Team Progressive Tax System Teachers

    • 10 minutes reading time
    • Checked by StudySmarter Editorial Team
    Save Explanation

    Study anywhere. Anytime.Across all devices.

    Sign-up for free

    Sign up to highlight and take notes. It’s 100% free.

    Join over 22 million students in learning with our StudySmarter App

    The first learning app that truly has everything you need to ace your exams in one place

    • Flashcards & Quizzes
    • AI Study Assistant
    • Study Planner
    • Mock-Exams
    • Smart Note-Taking
    Join over 22 million students in learning with our StudySmarter App