Definition: Progressive tax is a type of taxation in which individuals or groups with high incomes pay a larger percentage than those with lower incomes. It is based on the idea that the more money one has the more ability they have to pay.
What Does Progressive Tax Mean?
Progressive taxes are considered incentives for citizens to accept job with relatively low pay because they will not have to pay a lot of taxes and it would help reduce inequality by dispersing money in a more even fashion by way of the government. Often progressive taxes have marginal tax rates that raise the percentage after income reaches a certain threshold rather than an increase on every dollar or other increment of current.
Let’s take a look at an example.
William is a college student and works odd jobs throughout the year. His income is only be $10,000. At this low threshold his tax liability is 10%. However if next year he continued doing his odd jobs but also worked a steady job in the city earning an extra $1,865, he would have to pay a 20% on the additional income and a 10% tax on the initial $10,000 income. This would continue until he reached the highest threshold per year on which he would have a 39.5% tax rate on all income over the top threshold.
This example shows how effective tax rates (average total of all rates) are typically lower than marginal rates. William’s marginal rate is 20%, but he actually paid 11.7% of his total income ($1,373 / $11,865).
There are other justifications for the rising tax rates. One is that the value and utility of a dollar to someone who makes an income in the lowest bracket has much more utility than someone who makes over $250,000 or $350,000 per year. Thus, the higher wage earners are losing less opportunity with each dollar given up to taxes. In other words, it hurts them less.
One of the main problems with tax systems that become too progressive is that people find ways around paying the taxes. For example, if it is cheaper for a company to hire attorneys and set up operations overseas than to pay the taxes, they will do that instead. The economist, Art Laffer, documented this phenomenon in the Laffer Curve where governments with higher tax rates tend to bring in less money than governments with lower rates.