Taxes can be categorized by the impact they have on the distribution of income and wealth. A proportional tax is a kind that puts the same relative onus on each taxpayer – i.e., where tax liability and income grow in relative scale. A progressive tax is recognisable by a larger than proportional growth in the tax burden in relation to the rise in income, and a regressive tax is recognisable by a less than proportional increase in the comparative liability. Therefore, progressive taxes are regarded as taking away inequalities in income distribution, but regressive taxes are found to have the effect of an increase in these inequalities.
The taxes that are often regarded as progressive include individual income taxes and estate taxes. Income taxes that are categorically progressive, however, can become less so for the upper-income categories – in particular if a taxpayer is allowed to reduce his tax base by claiming deductions or by removing some income components from his taxable income. Proportional tax rates that are applied to lower-income classes would also be more progressive if such exemptions of a personal nature are declared.
Income measured over the period of a year might not necessarily give the best measure of taxpaying requirements. For example, transitory rises in income can be saved, and during temporary declines in income a taxpayer may elect to finance consumption by taking from savings. Thus, if taxation is regarded along with “permanent income,”it will be less regressive (or more progressive) than if compared with annual income.
Sales taxes and excises (save those on luxuries) are usually regressive, because the share of one’s income consumed or spent on a specific good declines as the rate of personal income is raised. Poll taxes (also termed head taxes), levied as a standard amount per capita, clearly are regressive.
It is hard to determine corporate income taxes and taxes on business as progressive, regressive, or proportionate, principally because of a lack of certainty regarding the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of nominating who bears the tax burden is dependant for the most part on whether a national or a subnational (that is, provincial or state) tax is being considered.
In assessing the economic effect of taxation, it is important to differentiate between various concepts of tax rates. The statutory rates will include those nominated in law; usually these are marginal rates, but for some cases they are median rates. Marginal income tax rates indicate the fraction of incremental income demanded by taxation when income is increased by one dollar. So, if tax onus increases by 45 cents when income increases by one dollar, the marginal tax rate is 45 percent. Income tax statutes often contain graduated marginal rates – i.e., rates that grow as income increases. Careful analysis of marginal tax rates should consider 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 greater than nominated within the statutory rates. Since marginal rates indicate how after-tax income is changed in response to changes in before-tax income, they are the appropriate ones for regarding incentive effects of taxation. It is even more complicated to know the marginal effective tax rate to apply to income from business and capital, because it may be reliant on factors 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 show the part of total income that is required in taxation. The pattern of average rates is the one that is in consideration for considering the distributional equity of taxation. Under a progressive income tax the average income tax rate rises with income. Average income tax rates commonly rise with income, both because personal allowances are granted for the taxpayer and dependents and also because marginal tax rates are graduated; on the flip side, preferential treatment of income received fundamentally by high-income households could dampen these effects, forcing regressivity, as displayed by average tax rates that decline as income grows.