Apr 13 2009
Understanding the difference between progressive and regressive taxes
Published by Jason Welker at 4:22 am under
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WikipediaBarack Obama and Joe Biden: The Change We Need | Taxes
The following was published in the Chicago Tribune’s “Voice of the People” page on October 29, 2008 in the midst of the US presidential race:
Redistributing wealth
On my way to lunch recently, I passed a homeless guy with a sign that read “Vote Obama; I need the money.” I laughed. In a restaurant my server had on an “Obama 08″ tie. Again I laughed. Just imagine the coincidence. When the bill came, I decided not to tip the server and explained to him that I was exploring the Barack-Obama-redistribution-of-wealth concept. He stood there in disbelief while I told him that I was going to redistribute his tip to someone who I deemed more in need—the homeless guy outside. The server angrily stormed from my sight. I went outside, gave the homeless guy $10 and told him to thank the server inside as I’ve decided he could use the money more. The homeless guy was grateful. At the end of my rather unscientific redistribution experiment, I realized the homeless guy was grateful for the money he did not earn, but the waiter was pretty angry that I gave away the money he did earn even though the actual recipient deserved money more. I guess redistribution of wealth is an easier thing to swallow in concept than in practical application.—A. Hart, Forest Park
The comment reflects a general contempt for the concept of taxation, specifically progressive taxes, or those that tax high income earners at a higher rate than those who earn low incomes. The idea behind a progressive tax, of course, is that higher income earners have income left over after they have provided themselves with the necessities of life, therefore should bear a larger burden of the nation’s tax revenue, which thereby enables the government to “re-distribute” wealth from the nation’s higher income earners across all levels of society through the provision of public goods.
The federal income tax in the United States is progressive in that the higher one’s income, the higher the percentage he or she pays to the US government. As seen in the table below, America’s poor will pay as little as 0-10% in income tax, while the nation’s richest households can pay up to 35%.
Opponents of progressive income taxes, which are also known as direct taxes because they are taken directly from a person’s income, argue that such a tax system creates a disincentive to work among American households. They argue that progressive income taxes penalize hard work and innovation, since the higher a worker’s productivity, the more of his income he must relinquish to the government.
One commonly misunderstood fact about the US income tax, however, is that it is a marginal tax system, meaning that when a person goes from, say the 25% to the 28% bracket, he does not pay 28% on ALL of his income, only on the marginal income above $82,250 (according to the 2009 column above). The implication is, therefore, that the average tax paid by an American will at any level of income be lower than the marginal tax. Below is a graphical representation of this concept. [source: http://aufrecht.org/pictures/images/858554/tax400.png]
It is the re-distributive intentions and effect of a progressive income tax system such as America’s (and every other country, click here to see tax rates from around the world) that has led to such intense opposition to the US tax system. Many in America’s government have proposed a “fair tax” that does away with America’s current direct tax system in favor of a nation-wide indirect, or sales tax on most goods and services. Watch the video below:
The fair tax is a indirect tax, meaning it is levied not directly on peoples’ income but indirectly on the purchase of goods and services in the economy, and is described as follows:
The sales tax rate, as defined in the legislation, is 23 percent of the total payment including the tax ($23 of every $100 spent in total—calculated similar to income taxes). This would be equivalent to a 30 percent traditional U.S. sales tax ($23 on top of every $77 spent before taxes).[4] The effective tax rate for any household would be variable due to the fixed monthly tax rebates that are used to “untax” purchases up to the poverty level.[3] The tax would be levied on all U.S. retail sales for personal consumption on new goods and services.
The two guests argue that the fair tax “is the only tax that totally untaxes the poor; the poor get a free ride totally across the board at the federal level under this plan.”
However, a national sales tax is a “regressive tax” meaning that as a percentage of income, the fair tax places a larger burden on lower income earners than higher income earners. An example is useful:
- Two shoppers walk into a computer store. One earns $50,000 a year, the other $100,000 a year.
- Both are looking at a computer that costs $2,000. Under the fair tax, $460 of the purchase price of this computer will go to the government as tax.
- $460 represents .92% of the income of the shopper who earns $50,000 per year.
- $460 represents .46% of the income of the shopper who earns $100,000 per year.
- The higher income earner pays a lower percentage of his income to the government in tax than the low income earner, making this a regressive tax.
One of the four macroeconomic goals governments aim to achieve in their policy making is more equal distribution of income. The fair tax, despite the arguments its advocates make, does not achieve a more equal distribution of income in America. It does place a smaller tax burden on the rich than the current system, but on the other hand America’s lower income earners bear a relatively larger burden of tax.
Discussion Questions:
- Are taxes necessary? Why? What are some of the “public goods” tax revenues are used to provide in America and your country?
- Discuss the claim that a progressive tax system stifles innovation, entrepreneurship and incentive to work.
- On whom does the largest burden of a sales tax (like the fair tax) fall? Is a sales tax “fair”? Why or why not?
About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. Jason was an international school student in Malaysia before studying economics at Seattle University then earning his Masters in Education. He calls Seattle and Northern Idaho home. In addition to maintaining an economics wiki and this blog for economics student and educators, Jason also gives presentations on using Web 2.0 tools in education at workshops and conferences around the world. His economics wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards". Related posts:
- Regressive or progressive taxes: Which road to follow towards fiscal discipline?
- Tax progressivity in the US: Do the rich pay more than their fair share? The evidence indicates NO!
- Advice to Republican presidential nominee on taxes – “raise ‘em!”
- Cut taxes on the rich! How else are they ever gonna catch up with the super rich?
- Loanable Funds vs. Money Market: what’s the difference?
Teachers!
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But does government really need to provide so many goods for free? Maybe thats why they are not noticed – because no-one wants/uses most of them. Also, they are not always for the benefit of everyone, like the “bridge to nowhere” for example. How about lowering federal taxes and increasing state taxes, moving pork spending to state budgets and therefore making the pork projects more accountable to local government, and local constituents? Otherwise there is a perverse set of risk rewards: only local constituents can vote in and out their representatives for federal gov. Why would they ever want to vote out their representative who brings the pork home paid for by a bank account funded by the rest of the country?
Personally, I feel that both sides of this argument have valid points. After reading this article I have come to the decision that wealthier individuals should pay higher taxes than those less fortunate. while there are some people who suddenly find themselves in serious debt or poverty because they have simply not put in the time or effort to change this, it is my overall belief that the majority of poor citizens suffer from the unfortunate truth that life is not fair and that opportunities and beginnings in life are obviously not equal. To say that a man sat in an office all day works harder than a poor merchant seller on the street is absurd. Having lived in Brazil I have had an up-close view of the poorer classes. This experience opened my eyes and showed me that some of the hardest working people in our world, the people who do the jobs that keep our societies running, earn close to nothing in wages. At first I thought that everyone should pay an equal percentage of taxes based on one’s income. After thinking it through I have concluded that that is not entirely fair. People who earn more money, the wealthier classes, have a greater possibility of saving money in a bank. Those who are poorer live from check to check where every penny counts and taxes place burdens on the poor that are often times too difficult to deal with. If the rich choose to live in moderation, as oppose to wasting all their money on an unnecessary amount of luxury goods, an increase in taxes will do little to alter their day to day lives. These taxes could then be used to help those in need, those who work hard but cannot break out of the “poverty cycle.”
I think you make a good point about how the McCain group mis-characterized Obama’s tax plan as socialism, but I think Obama’s proposed tax cuts is a mis-representation itself. The story attached to the following link shows how marginal tax rates will actually go up for most people under the Obama tax plan.
http://www.american.com/archive/2008/august-08-08/the-folly-of-obama2019s-tax-plan
I also think it is important for people to realize that the so-called upper class of society already pays a huge portion of the taxes. So to say they need to pay their fair share is wrong, they already are and have been for some time. The following link shows how they are currently paying and how many people aren’t paying taxes.
http://www.heartland.org/policybot/results.html?artId=23876
I’m not for one plan or the other. I just want people to see the truth behind what is being said publicly.
I personally think taxes are necessary in life, to make sure that wealth distribution of wealth is fair. During George W. Bush there was small upper class of about 10%, which possesed 70% of the wealth of the US and there was the lower class, which faught for the remaining 30% of wealth in the country. So Taxing the really rhich people won’t hurt really anybody, because the rhich will still be rhich after. About the fact that McCain has critsized Obama about his plans, calling him a socialist, I can only laught about. He critisizes that Obama is aiding more the people, who live on the streets and haevn’t even searched for work, while stealing from the hardworking people. Well, why are people living on the streets? They could have had a job, lost it and did not find another one, or their education wasn’t good enough. McCain also forgot to see that there are workers, who work just as hard, as for example a banker does, but get much less income and therefor have to go begging. I have lived in Talinn, Estonia and Sao Paulo, Brazil, where many people are poor and I can say that everyone works so hard it’s just unbelievable.
Taxes can also be put on products, like ciggarets, weapons, drugs, whatever hurts the human being. So I personally think that what Obama is doing is correct.
Justus I agree with your points above however you say: “Taxing the really rich* people won’t hurt really anybody, because the rich will still be rich after.” Do you believe then that they should pay a higher percentage tax on income, as well as increasing the tax on luxury goods as it is mostly likely the super rich that are currently fueling the luxury goods market, even more so now with the economics slump, as middle class consumers are not able or willing to purchase a loan to acquire them. It will be interesting to see the effects of Obama’s Tax policy, when he comes into office.
I believe that cutting the taxes for the middle class is exactly what needs to be done right now in the current situation of the economy. Justus said that 10% of the population own 70% of the wealth, first of all it is not fair, because I am certain that at least one of the other 90% is working hard too and also those 10% are probably not spending it all. The middle class is the largest part of the population so they are the only ones who can most effectively do something against the current crisis. By lowering the taxes it encourages the middle class to spend more and lets the economy grow.
Martin and Justus, your rhetoric only enforces the notion that taxes are for punishing rich people. Once this tax is taken, how does it ever get back to the middle class in a form where they actually notice a difference? Further, some really smart people analyzed Obama’s actual plan and found that it would be adding taxes to the lower classes, not granting them a break. Check it out:
http://www.american.com/archive/2008/august-08-08/the-folly-of-obama2019s-tax-plan
Second,
Capitalism has never been about rewarding people who work hard. Also, what is the definition of hard work? Sweat? Time? People on Wall Street may rarely break a sweat, but they are at their desks from 6am to 3 am sometimes, is that not hard work? When do factory workers in Detroit ever put in hours like that? (The union would never allow it! This while GM and Ford have to pay them a pension for the rest of their lives retirement, which is a growing burden as life expectancy expands)
Capitalism is about rewarding those who create goods and services that are valued alot by many people. I could work really hard cleaning toilets my whole life, but at best I can only clean 100 toilets in a day, and few people in the world would ever sit on my toilets. But if I work really hard to invent a self cleaning toilet and sell the technology to those who want a clean toilet, I can sell clean toilets to more than 100 toilet users in a day. And I will be paid more.
To do so, I would have to spend the time researching the self-cleaning toilet and putting my own time and money into developing the product – putting my own well being at risk. What if no one buys my product? Its a scary proposition and maybe I would prefer the certainty of cleaning my 100 toilets by hand. What keeps me in the game? It is the prospect of an outcome where my idea would pay me more than washing toilets by hand, despite the risk of failure. When my upper bound is taxed away, it is a scarier proposition to put my well being at risk and thus I am less likely to innovate and provide a better product than hand washed toilets. And that is the problem with taxing high income earners. The death tax is already a way in which large sums of money from rich families gets redistributed anyways. So let the people who made your life better be rewarded for their successes while they are alive. Then tax the hell out of them after they die.
Overall I think taxes are necessary to have an economy run. Taxes are used by the government to help the people being taxed. For example, the government uses the taxes to build roads for you to drive on. That is just one of many examples. The progressive income tax posses a higher tax on people who make more money making rich people pay more than poor people. A flat tax on income means that everyone pays the same percentage of their income which I believe is unfair because people who are not making as much need the money more then the CEO’s making tons and tons of money a day. I think that the sales tax idea has promise. It is an indirect tax to the rich people because they tax luxury goods and the only people who can afford luxury goods are the rich.
I agree with Dan, taxes are a necessary for a country to run efficiently and to run at all. In order for a government to gain revenue they must tax the people, after all the taxes imposed are there to benefit the people. More specifically income taxes are there to help the people. That revenue is there to pay for health care and other such things. However I agree with Joe the Plumber where he believes that there should not be such a high income tax but should be taxed on flat rate where everyone would pay the same tax and would not be taxed as heavily because they have worked hard. I believe that those who have worked hard and tried to earn their money should be allowed to keep it. I don’t agree with the idea of a tax on luxury goods as they are an inelastic good and should price increase because of the tax demand will decrease therefore decreasing revenue.
Taxes are indeed necessary since they are part of a cycle that affects both consumers and producers. Even though it may seem like a waste of money and an unnecessary cause to pay the government, in return, the government collects our tax payments and uses it to build roads, hospitals, educational systems, etc. Therefore, our tax payments are actually there to provide help for us. Moreover, I personally think that taxes should be slightly lowered, as Martin said, so that consumers and producers feel more comfortable in that area, however this should not mean that only the rich should pay higher taxes; a certain percentage of each person’s income might not be the same, but who is to distinguish between who is poor and who is rich? Giving a fixed percentage value on taxes might seem like it is affecting the poor more, however the rich also have to pay a larger amount of their income to full fill these taxes.
i find it a step in the right direction. The whole idea of americanism in the first place was to allow every man an equal standing from which to build his wealth in a free system. This tax system is for the people who actually believe in the hope for a fair society. It might give disincentive to the self-interested people in the society, but that is the cost. The problem is, that i doubt it will help the ailing economy. This is more of an idealistic plan for better times. Giving money to people who need it only means that less people will have surplus cash with which to buy luxury goods. A whole country with people buying only necessities might lead to the collapse of many companies like apple or maybelline. This would be especially disastrous for america. Thnx for trying Obama, but not right now.
We can tell that he hasn’t a clue why we have tax’s in the first place. They are needed for all kinds of areas, such as the military, schools, fire and police services ect. Without tax the country would fall into caos and their would be no laws as no goverment could exist. We would go back to a primitive society with no order.
Joe wants a flat tax, which is a tax everyone needs to pay no matter what level of income. It doesnt warry depending on the amount a person earns. He wants flat tax to replace progressive tax which is where the more you earn, the higher percentage of your income you pay in tax. The benefit of progressive tax is that it takes a burden off the poor, as they dont have to pay as much giving them more money to spend and live.
As Dan said, taxes are necessary for any economy to function properly. With the American economy in the state it is right now, the progressive taxes, taxes that take a larger percentage from the income of high-income people than they do from low-income people, which Obama has proposed are the best option. While it is understandable for people who make more money to argue against this claiming that they deserve more money because they have worked harder, this will not always benefit the economy. For example, when very wealthy people have higher real incomes and will spend more. However, they are more likely to buy luxury goods, which are commonly imported goods. This will further worsen the United States already $10.6 trillion budget deficit sending the nation further into debt. If it is poorer people, however, that receive the tax break, they will most likely spend their money on cheaper, domestically made goods from Wal-Mart, or a shop of that sort.
Jenny- do you honestly believe that the goods sold at places like walmart are made in America?Second of all, the economy is in a state where lending has dried up. This is because people who need to borrow are becoming more and more unable to pay back their loans. Surely we should be focusing on creating conditions that encourage these people/institutions with excess funds to be more willing to open their wallets and lend rather than taxing their extra dollars. That only makes them more likely to horde what they have left. Our economy is blowing up not because some rich people are either not spending anymore or buying luxury goods from other countries, its because the government induced conditions that caused excess lending to people who have no business receiving the kinds of loans they got. Now the markets have realized that money is never coming back, and companies (and a lot of formerly rich people) have to move on hoping that the loans will get paid back or that they can sell them to some other suckers without losing too much. Putting money in the hands of “poor” people is not a way to boost an economy. People of all affluencies need to feel safe spend as much as they were before. However I think we are witnesses to a paradigm shift where we are unlikely to see the U.S. returning to the spending levels we used to be at both because people want to have a bigger savings safety net and there will probably be fewer lenders out their to fund the most recent version of the American Dream, namely, “borrow and buy now, make our kids pay back later”.
To the rest of you about taxes, obviously there are public goods that need to be provided by a government. But my point was that we don’t tax in order to create equality. We should also structure taxes so that they do not create incentives that destroy economic and technological advances. To the degree that we tax as a punishment, it should be on things which cause unfair costs on society – e.g. smoking/drug use, polluting, DUI etc.
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