Question

What is the difference between a progressive tax and a regressive tax? Give an example of each.

Short answer

A progressive tax is one where the tax rate increases as the taxable amount increases, with higher earners paying a larger proportion of their income in taxes. An example is income tax. A regressive tax is one that takes a larger proportion of income from low-income earners than from high income earners with everyone paying the same tax rate. An example would be sales tax.

Step-by-step solution

Define Progressive Tax

A progressive tax is a tax in which the tax rate increases as the taxable amount increases. It is structured so that people or corporations with higher incomes pay a larger proportion of their income in taxes compared to those with lower income.

Example of Progressive Tax

An example of a progressive tax is income tax. Here, a person who earns $20,000 a year might pay 10% of their income in tax, whereas a person earning $200,000 a year might pay 35%.

Define Regressive Tax

A regressive tax is a tax that takes a larger proportion of income from low-income earners than from high-income earners. It is the opposite of a progressive tax.

Example of Regressive Tax

An example of a regressive tax is sales tax. In this case, everyone pays the same percentage regardless of their income. This means that someone earning $20,000 and someone earning $200,000 would both pay the same rate, say 7% on a $10,000 purchase. As a percentage of their income, the lower earner is paying a higher portion than the higher earner.

Key concepts

Progressive Tax

In a progressive tax system, tax rates increase as income levels increase.
This means that individuals or entities with higher incomes bear a greater tax burden compared to those with lower incomes.

How It Works

At its core, the system is designed to collect more tax revenue from those who can afford to pay more. For instance:

• Lower-income earners might pay a smaller percentage of their income, say 10%.
• Meanwhile, higher-income earners could be taxed at a rate of 35%.

The key element of progressive tax is the rate structure, which includes multiple tax brackets.
As income crosses into higher brackets, the portion that crosses these thresholds is taxed at a higher rate.
This system is thought to promote equity, since those with greater financial ability contribute more to public resources.

Regressive Tax

A regressive tax framework contrasts sharply with progressive taxes.
Here, lower-income individuals, in fact, end up spending a larger percentage of their earnings on taxes than higher-income individuals.

Example and Impact

Sales tax is often cited as an example of a regressive tax:

• If everyone, regardless of income, pays a 7% sales tax on goods purchased, the effect is regressive.
• For someone with a modest income, that sales tax represents a more significant portion of their overall earning than it does for a higher-income individual.

The essence of a regressive tax is that it affects the economically vulnerable more significantly.
Often, basic goods and necessities are subject to the same tax rates, which adds to the regressive nature when considering proportional spending.

Income Tax

Income tax is a staple of progressive tax systems and is charged on various forms of income.
It accommodates different sources such as wages, salaries, and investments.

Components

Understanding income tax involves looking at its different components:

• Ordinary Income: This includes salaries and wages which are usually taxed progressively.
• Capital Gains: These can sometimes be taxed at different rates to promote investment.

Governments use income tax revenue to fund essential services like:

• Education
• Healthcare
• Infrastructure development

The effectiveness of income taxes in redistributing wealth depends on the rates and brackets and seeks to strike a balance between economic growth and equity.

Sales Tax

Sales tax is a consumption tax imposed on the sale of goods and services.
It is generally a fixed percentage, collected at the point of sale.

Operation and Challenges

Sales tax features include:

• A specific percentage added to the final purchase price paid by the consumer.
• The same rate applied to everyone, irrespective of earnings.

While straightforward in collection, sales taxes can be seen as burdensome on lower-income individuals, since they spend more of their income on everyday items.
This challenge can be mitigated by exempting essential items like food and medicine from sales tax.
Sales tax typically funds local and state government services, supporting community projects and local governance.