Types of Taxes: Progressive, Proportional and Regressive.

Most taxes can be classified as progressive, proportionate or regressive. A progressive tax takes a larger percentage of a higher income and a smaller percentage of a lower income. The federal income tax is the best known example of a progressive tax.

A proportionate tax takes the same percentage of all incomes, regardless of size. So, for example, a proportionate income tax of 10 percent would cost a person with a $10,000 income $1,000 in taxes, and a person with a $100,000 income $10,000 in taxes.

A regressive tax is one that takes a higher percentage of a low income and a lower percentage of a higher income. Although they are not based on a person’s income, sales taxes have a regressive effect because they take a larger share of earnings from a low-income taxpayer than from a high-income taxpayer. For example, a low-income family and a high-income family buy $500 refrigerators with a sales tax of eight percent. They would both pay a $40 sales tax. But the $40 represents a higher percentage of the low-income family’s total income than that of the high-income family.

Which tax is the fairest?

Few would argue that a regressive tax is fair. Those who favor the ability-to-pay principle would support a progressive tax, and possibly the proportionate tax. There are some, however, who argue that the proportional tax is not fair.

The proportional tax seems to be fair because everyone pays the same rate. Miss Rich, with her income of $100,000 pays 10 times as much as Mr. Poor who has an income of $10,000. Mr. Poor, however, can barely get by on $10,000; he needs every penny he earns. Miss Rich, on the other hand, can pay a tax of $10,000 and still have $90,000 left over – a very substantial sum! She can pay for all of her basic needs, enjoy main luxuries and still have money left to save or invest. Although her tax was 10 times as large as Mr. Poor’s, she didn’t suffer as much in laying it.

In analyzing the impact of taxes on individuals, economists often concentrate on discretionary income – the amount that a person has left buying necessities (food, clothing, shelter, medical care, transportation, etc.). Let’s assume that Mr. Poor has $1,000 left after having met all his needs. By levying a tax of $1,000, the government has taken 100 percent of Poor’s discretionary income. What about Miss Rich? Let’s say that she needs $50,000 to meet all of her needs (as she defines “needs”), and that she has $50,000 left as her discretionary income. The government takes $10,000 of this, or only 20 percent. She still has $40,000 left for luxuries, savings and investments. If we look at the discretionary incomes of Mr. Poor and Miss Rich, we find that the proportional tax is really a regressive tax!

Who really Pays the Tax?

In evaluating a tax it is important to know who will really have to pay it, or, as economists put it, the incidence of tax. The burden of paying a tax can be avoided if one responsible for writing the check for taxes to the government can pass the cost to someone else. The process of passing the burden to someone else is known as tax-shifting. Taxes may be passed on to consumers, in which case they are said to be shifted forward. Similarly, taxes may be shifted backward as when suppliers or the workers who produced the products are forced to assume the burden.

Whether taxes are shifted forward, backward or not at all will depend upon the elasticity of demand and supply. When demand is relatively inelastic, it is easier for sellers to shift taxes to buyers. When supply is relatively elastic, the seller is more likely to assume the burden of taxes.

Suppose cigarettes cost £1 a packet in the absence of a cigarette tax and the government imposes a tax of 50p per packet. Do cigarette smokers end up paying the tax or is it borne by manufacturers of cigarettes? It all depends on how much of the tax cigarette producers can pass on to the consumer. We now show that this depends on the slopes of the supply and demand curve.

In parts (a) and (b) of the figure we plot the (after-tax) price to the consumer on the vertical axis. DD' shows the demand curve, which depends on the price to cigarette smokers (consumers). Since the price received by the producer is the consumer price minus the 50p tax per packet, the effect of levying the tax is to shift the supply curve from SS to SS" in both diagrams. Each possible quantity supplied depends on the price received by the producer, which will be the same as before only if consumer prices are 50p higher; that is why we must shift the supply curve up by 50p.

(a) Steep demand, flat supply

Q, Q₂

Quantity

In part (a), with a flat supply curve and steep demand curve, the tax is borne mainly by cigarette consumers. Point В is nearly 50p higher than point A. Since demand is inelastic, producers can pass on most of the tax in higher prices. Supply is elastic, so any significant drop in the price received by producers would lead to a large drop in the quantity produced. Consumers pay £1.45 and producers get £0.95 a packet. In part (b), with a flat demand curve and a steep supply curve, most of the tax is borne by cigarette producers. Demand is elastic, so attempts to pass on the tax in higher prices quickly lead lo a drop in the quantity of cigarettes sold. Supply is inelastic, and firms produce nearly as many cigarettes even though the price they receive (after tax) has fallen nearly 50p from point A lo point C. Consumers pay £1.05 and producers get £0.55 a packet.

(b) Flat demand, steep supply

Q, Q₂

Quantity

Incidence refers to the individual or business that will bear the burden of a tax. For example, in many localities businesses have to pay a sales tax on their gross receipts. If, for example, your community charged a 5 percent sales tax, a store with $1,000 in sales would have to pay $50 in taxes. But sales taxes are normally added on to the selling price of a good or service. In other words, the incidence of a sales tax falls upon consumers.

Exercise 1. Answer the following questions:

1. When the government increases the sales tax on a product, who pays this tax?

2. Give an example of a good where the tax is mainly passed on to the consumer, and a good where it is largely borne by the producer. Why is this?

Exercise 2. Describe and compare parts (a) and (b) of the figure. Explain the possible influence of the tax increase on the demand for and the supply of cigarettes.