What is a Progressive Tax?

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Definition:

A progressive tax system is one in which the tax rate that an individual pays increases in proportion to their income.

🤔 Understanding progressive tax

In a progressive tax system, high earners pay a higher tax rate than low earners. In this type of tax system, we assume that those making a lot of money can afford to spend a more significant percentage of it in taxes, whereas those making little money need more of it to get by. A tax system can become more or less progressive by increasing or decreasing the margin between the highest and lowest tax rate. The United States has progressive income taxes, meaning as your income goes up, so does your tax rate. Several other taxes, such as the estate tax, are also progressive taxes, while others — such as the sales tax — are regressive taxes. A regressive tax is one where low earners pay a higher percentage of their income in taxes.

Example

Suppose Dan has been making $80,000 per year in his job. His employer offers him a promotion, where he will now make $120,000 per year. Dan’s promotion has pushed his income into a higher tax bracket, meaning he’ll now be paying a higher tax rate on his income. The government has decided that Dan’s higher income means he should be able to afford paying a greater percentage of his income in taxes.

Takeaway

A progressive tax system is like an airplane…

The better the seat you have on the plane, the higher the cost you’ll have to pay for your ticket. The worse the seat you have, the less you’ll have to pay. Similarly, the better your income, the more you have to pay in taxes — not just in total dollars, but as a percentage of your income.

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How do progressive taxes work?

In a progressive tax system, the percentage that someone pays in taxes increases as their income increases. So the higher someone’s income, the higher the tax rate they pay; the lower someone’s income, the lower the tax rate they pay.

The United States has a progressive income tax system with seven different tax brackets ranging from 10%–37%. As of 2020, those individuals with an income of $9,875 or less pay only a 10% tax on their income. Those making more than $518,400 pay a 37% tax on the portion of their income that falls above that threshold.

Here is a breakdown of the progressive income taxes in the United States, based on the income of a single individual:

  • 10% for income $0-$9,875
  • 12% for income $9,876-$40,125
  • 22% for income $40,126-$85,525
  • 24% for income $85,5260-$163,300
  • 32% for income $163,301-$207,350
  • 35% for income $207,351-$518,400
  • 37% for income $518,401 or more

The United States uses marginal tax rates, meaning each income tax rate only applies to a certain portion of your income. For example, everyone pays a tax rate of 10% on the first $9,875 of their income. Those earning between $9,875 and $40,125 pay a marginal tax rate of 12%, but only on the income in that range. This system helps to ensure that an increase in income doesn’t unfairly impact taxpayers and that no one is paying more than their fair share in taxes.

In the United States, your marginal tax rates are based on your adjusted gross income, not your actual income. Your adjusted gross income takes into account certain deductions that can help you to lower your taxable income. The United States also has plenty of tax deductions that can help individuals to lower their taxable income and move them into a lower tax bracket. The standard deduction, which is available to all taxpayers, reduces someone’s taxable income by $12,400. Other itemized deductions are available to specific individuals, such as those people who have paid student loan interest, donated to charity, or contributed to an individual retirement account (IRA).

What are the advantages and disadvantages of progressive taxes?

Proponents of a progressive income tax system point out that the higher someone’s income, the more they can afford to contribute toward income taxes. Someone who is earning six figures is likely to have more wiggle room in their budget than someone who is living at the poverty line and is barely scraping by.

Not only do progressive income taxes allow low earners to keep more of their income, but income taxes also go to pay for many programs that help lower-income individuals financially.

These programs include Medicaid, which provides health insurance to individuals living in poverty. Many argue that this helps to keep everyone’s expenses lower in the long run because it allows low earners to seek preventative care. Otherwise, they might be racking up higher medical bills by waiting to seek medical attention until they require a visit to the emergency room. Another example is the Earned Income Tax Credit, which provides a tax credit for low-income earners.

Those in favor of progressive income taxes also argue that savings for low-income individuals have the most significant economic impact, more so than savings for high-income individuals. The reason for this impact is that low earners tend to spend their entire income each year, which helps to stimulate the economy. High earners, however, save more of their money rather than spending the whole amount.

There are also plenty of critics of the progressive income tax system. Opponents of the progressive tax system argue that these taxes discriminate against high earners because it forces them to pay more than their fair share.

In the United States, especially, high-income individuals don’t benefit from many of the social welfare programs that their tax dollars help to pay for, so progressive taxes face criticism as a type of unfair income redistribution. Critics also argue that a progressive tax system disincentivizes hard work and success since, it results in people paying a higher tax rate as their income increases.

Which other countries have a progressive tax system?

The United States and many western countries have progressive income tax systems, under which those who make more money pay a higher percentage of their income in taxes.

Canada Canada has a progressive income tax system with five different tax brackets ranging from 15% to 33%. The lowest tax bracket of 15% applies to any income of $48,535 (CAD) or less. The highest tax bracket of 33% applies to any income of $213,368 (CAD) or more. The tax rates in Canada are marginal like those in the United States.

Mexico Mexico also has a progressive income tax system. The lowest earners, those making less than 6,942.36 (MXN), pay just 1.92% in income taxes on their earnings. The highest income tax rate in the country is 35%, but that rate only applies to income exceeding 3,498,600.12 (MXN). The tax rates in Mexico are marginal like those in the United States.

United Kingdom In the United Kingdom, there are four income tax rates ranging from 0% to 45%. Individuals do not have to pay income taxes on earnings of ÂŁ12,500 or less. The highest tax rate of 45% applies to income that exceeds ÂŁ150,000. The tax rates in the United Kingdom are marginal like those in the United States.

Germany Individuals in Germany pay income taxes in four progressive income tax brackets ranging from 0% to 45%. Those earning €9,408 or less pay no income tax on their income. And earners making more than €270,500 pay a rate of 45% on the highest of their income. The tax rates in Germany are marginal like those in the United States.

What is the difference between a progressive tax and a regressive tax?

Where a progressive tax charges a higher rate to those with higher income, a regressive tax results in low earners paying a higher percentage of their income in taxes. Several taxes in the United States fall into the category of regressive taxes, including sales taxes, user fees (those we pay for a certain service), property taxes, and sin taxes (tax imposed on items we deem harmful to society, like alcohol and tobacco).

Regressive taxes are actually the result of uniform taxes that impact specific individuals differently. For example, the sales tax in Wisconsin is 5%. Everyone pays the same 5%, regardless of their income. However, that 5% in sales tax eats up a more significant percentage of the income of someone earning $25,000 than it would someone earning $50,000. Let’s say the person earning $25,000 per year paid $500 in sales tax over one year. They spent 2% of their income on sales tax. If the person earning $50,000 per year spent the same $500 on sales tax, it would only amount to 1% of their income.

Some states rely more heavily on regressive taxes to fund their state spending. Nine states — Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming — have no state income tax. Instead, those states rely on other forms of tax revenue to pay for state services. In many cases, they make up for this shortfall with sales and property taxes, which are regressive taxes. Therefore, some states have a more regressive tax system than others, meaning low-income individuals are shouldering a disproportionately large tax burden in paying for state spending.

What is the difference between a progressive tax and a flat tax?

Unlike progressive and regressive taxes, which result in taxpayers a different rate based on their income, flat taxes charge all taxpayers at the same rate in proportion to their income. If the tax rate is 10%, you pay 10% in taxes, whether your income is $10,000 or $100,000. Some also refer to flat taxes as proportional taxes.

The United States does not have a flat income tax, but there are still examples of a flat tax in the country. The Social Security tax (the tax that pays for benefits the Social Security Administration provides for seniors and disabled individuals), for example, is flat. All income earners pay 6.2% of their income in taxes, regardless of how much money they make. Likewise, all self-employed individuals pay 12.4%, since they pay both the employer and the employee share of the tax.

As a note, you could also consider the Social Security tax to be a regressive one. The Social Security tax only applies to income of $137,700 or less as of 2020. Therefore, people earning more than that amount end up paying a smaller percentage of their total income than those earning less than that amount. But if you only take into account those earning less than $137,700, it is a flat tax.

Some countries use a flat tax for their income taxes — Russia is the largest. Russia charges all taxpayers a flat rate of 13% of their earnings. Other examples of countries that have a flat-rate income tax are Estonia, Latvia, and Lithuania.

Which tax system is best?

It’s impossible to say with certainty what the best tax system is between progressive, regressive, and flat taxes. All three models have supporters and critics. In the United States, the government opts to use all three systems in tandem, presumably so that one income group is not always disproportionately affected. Different political parties tout the fairness of different tax systems, and one can certainly make an argument for all of the models.

Though the United States currently has a progressive income tax system, some people have argued that the United States should implement a flat income tax, claiming that it would provide a more level playing field. The current income tax system in the United States means that the more you make, the higher percentage you pay in taxes. Some argue that this disincentivizes income growth and that taxpayers might be more motivated to excel in their careers if they weren’t worried about paying more in taxes.

Because of the way the marginal tax rates work in the United States, an income tax rate only applies to the income that actually falls into the income range for that tax bracket. However, plenty of misunderstanding regarding the tax system has led some to believe that moving into a higher tax bracket means one’s entire income will be taxed at a higher rate.

Policymakers have proposed various flat tax models in the United States. Most of these proposals eliminate all deductions and exemptions that currently exist. They also eliminate income taxes on investment income, like dividends and capital gains. Some politicians have suggested flat tax systems that maintain the deductions now available.

Opponents of a flat tax model argue that these taxes are harmful to low-income individuals since they need more of their income to pay for living expenses. These opponents compare a flat tax to a regressive tax since low earners feel the impact more than high earners.

Ultimately, the government relies on tax dollars to function. All parts of government spending from schools to wars require individuals to pay taxes. As Supreme Court Justice Oliver Wendell Holmes, Jr. said in 1927, “Taxes are what we pay for civilized society.”

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