Tax systems fall into three main categories within the tax code: regressive, proportional and progressive taxes. Regressive taxes are those that have a greater impact on low-income individuals than high-income earners. A proportional tax, also referred to as a flat tax, impacts low-, middle- and high-income earners relatively equally. A progressive tax has more of a financial impact on higher-income individuals and businesses, and less on low-income earners. The U.S. federal tax system and local and state tax systems use all three types to collect tax revenue.
Under a regressive tax system, individuals and entities with low incomes pay a higher amount of that income in taxes compared to high-income earners. Rather than basing the tax on the individual or entity's earnings or income level, the government assesses tax as a percentage of the asset that the taxpayer purchases or owns.
For example, a sales tax on the purchase of everyday products or services, such as food and clothing, is assessed as a percentage of the item bought, and is the same for every individual or entity. Shoppers pay, say, a 6% sales tax on their groceries, whether they earn $30,000 or $130,000 annually. Because the buyer's wealth (and hence, ability to pay) is not taken into consideration, this sales tax – while nominally the same for all shoppers – effectively places a greater burden on lower-income earners than it does on the wealthy: The former end up paying a greater portion of total income than the latter. For instance, if a person makes $20,000 a year and pays $1,000 in sales taxes on clothing and other consumer goods, then 5% of his annual income goes to sales tax. If a person makes $100,000 a year and pays the same $1,000 in sales taxes, then only 1% of his income goes to sales tax.
Comparing Regressive, Proportional and Progressive Taxes
Aside from state and local sales taxes, regressive taxes include real estate property taxes and excise taxes (a fixed tax included in the price of the product or service) on consumables such as gasoline or airfare. Sin taxes, a subset of excise taxes, are imposed on certain commodities or activities perceived to be unhealthy or have a negative effect on society, such as cigarettes, gambling and alcohol (in an effort to deter individuals from purchasing those products). Sin-tax critics argue that these disproportionately affect the less well-off not just because of economics, but because these lower-income groups tend to indulge more in these items or activities.
Many also consider Social Security a regressive tax. Social security tax obligations are capped at a certain level of income. This means that once an individual reaches that income threshold ($128,700 in 2018), any wages he earns above that are not subject to the 6.2% FICA bite. In other words, the annual maximum that one pays in Social Security tax is "capped" at $7,979 (in 2018) – whether one earns $128,701 or $300,00 or $1 million. Because of this cap, higher-income employees effectively pay a lower proportion of their overall income into the Social Security system than lower-income employees do.
Under a progressive tax system, the taxes assessed – say, on income or business profits – are based on the taxable amount, and follow an accelerating schedule. High-income earners pay more than low-income earners, and the tax rate, along with tax liability, increases as an individual or entity's wealth increases. The overall outcome is that higher earners pay a higher percentage of taxes and more money in taxes than do lower-income earners. This sort of system is meant to affect upper-class people more low- or middle-class individuals – to reflect the fact that they can afford to pay more.
The current U.S. federal income tax is a progressive tax system. Its schedule of marginal tax rates imposes a higher income tax rate on people with higher incomes, and a lower income tax rate on people with lower incomes. As taxable income increases, the percentage rate increases at each interval as the income level moves across the schedule. With a marginal tax rate, each dollar the individual earns places him into a bracket or category, resulting in a higher tax rate once the dollar amount enters a new category.
To understand the marginal tax rate system, consider the following schedule: a first tax rate of 10% for taxable income less than $10,000, a second rate of 15% for taxable income between $10,000 and $30,000 and a third rate of 25% for taxable income between $30,000 and $60,000.
According to the schedule, if a taxpayer's income is $50,000, the third rate of 25% does not apply to the full $50,000 of income. Instead, the taxpayer owes 10% for the first $10,000 of income, 15% for $20,000 of income at the second rate amount between $10,000 and $30,000, and 25% for the remaining $20,000 that falls into the third tax rate. The taxpayer in this example owes a total of $9,000, because the 10% rate on the first $10,000 is $1,000, the 15% rate on the next $20,000 is $3,000, and the 25% rate on the remaining $20,000 is $5,000.
Part of what makes the U.S. federal income tax progressive is the personal exemption, a feature that has been available since the first taxes were collected in 1915. The personal exemption means individuals do not pay taxes on the first bit of income they earn each year, and this amount changes from year to year. Due to personal exemptions, deductions and tax credits, many low-income Americans pay no federal income tax at all. When the economy is stable and unemployment is low, as many as 40% of U.S. citizens don't pay income taxes because their earnings are too small to reach the lowest tax rate.
As with any government policy, progressive tax rates have critics. Some say progressive taxation is a form of inequality and amounts to a redistribution of wealth, as higher earners pay more to a nation that supports more lower-income earners. Those who oppose progressive taxes often point to a flat tax rate as the most appropriate alternative.
A proportional tax system, also referred to as a flat tax system, assesses the same tax rate regardless of income or wealth. It is meant to create equality between marginal tax rate and average tax rate paid.
For example, under a proportional income-tax system, individual taxpayers would pay a set percentage of their annual income, regardless of the size of that income. Say the fixed rate is 10%. Since it does not increase or decrease as income rises or falls, an individual who earns $20,000 annually pays $2,000, while someone who earns $200,000 each year pays $20,000 in taxes.
Proponents of proportional taxes believe they stimulate the economy more by encouraging people to work more, as well as spend more. They also believe businesses are likely to spend and invest more as well under a flat tax system, putting more dollars into the economy.
The Bottom Line
A progressive tax is one that increases along with an individual's means, while a regressive tax doesn't consider the individual's means (and thus often penalizes those with less). Proportional taxes are applied equally to all income groups.