Progressive Tax System

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.

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.

Fig. 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. P_tax – 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.

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.

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.

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.

Fig. 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!

Let's now take a look at a chart of what a progressive tax system might look like.

Fig. 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.