Taxes in which the rate of tax remains constant, though the tax base changes, are called proportional taxes.
Here, the tax base may be income, money value of property, wealth, or goods etc. Income is, however, regarded as the main tax base, because it is the determinant of taxable capacity of a person.
In a proportional tax system, thus, taxes vary in direct proportion to the change in income. If income is doubled, the tax amount is also doubled.
Thus, a proportional tax extracts a constant proportion of rising income.
Taxes in which the rate of tax increases are called progressive taxes. Thus, in a progressive tax, the amount of tax paid will increase at a higher rate than the increase in tax base or income, for the taxation amount is the product of multiplying the base by the rate and both these increase in a progressive tax. Thus, a progressive tax extracts an increasing proportion of rising income.
When the rate of tax decreases as the tax base increases, the taxes are called regressive taxes.
It must be noted that in regressive taxation, though the total amount of tax increases on a higher income in the absolute sense, in the relative sense, the tax rate declines on a higher income. As such, relatively a heavier burden (sacrifice involved) falls upon the poor than on the rich. Generally, taxes on necessaries are regressive as they take away a greater percentage of lower incomes as compared to higher incomes.
Thus, regressive taxation is unjust and inequitable. It does not comply with the canon of equity. It tends to accentuate inequalities of income in the community.
Taxes which are mildly progressive, hence not very steep, so that high income earners do not make a due sacrifice on the basis of equity, are called digressive. In digressive taxation, a tax may be progressive up to a certain limit; after that it may be charged at a flat rate.
In digressive taxation, thus, the tax payable increases only at a diminishing rate.
Diagrammatically, differences in progressive, proportional, regressive and digressive taxation are shown in Fig. 1.
Fig. 1 depicts the proportion of income taken away in taxation under different tax rates. Tax line a represents a progressive tax rate, tax line b represents a proportional tax rate, tax line с shows a regressive tax rate and tax line d denotes a digressive tax rate.
The proportional tax rate has a constant slope, graphically, while the progressive tax rate has a rising positive slope. The steeper the slope of the tax line, the progressive the tax regime. The regressive tax rate line has a declining negative slope. The steeper the negative slope of the tax line, the more regressive the taxation. The digressive tax rate line has a rising slope initially, but it becomes constant after a point.
In a nutshell, we may put this:
- When there is no change in the marginal rate of tax:
D (dR/dy) = 0, taxation is proportional.
- If, D (dR/dy) > 0 (i.e., positive change in the marginal rate of tax), where dy > 0; taxation is progressive.
- If, however, D (dR/dy) < 0 (i.e., negative change),
Where dy > 0; taxation is regressive.
- If, however, D (dR/dy) > 0 (i.e., positive-cum- constant), where dy > 0, taxation is digressive.
Now the question may arise: of the above stated categories of rate structure, which is the best? The answer should be: We have to select that tax system which will distribute the tax burden most equitably. Regressive and digressive taxation are, of course, not accepted by any economist on the ground of equity. But, there has been a heated controversy regarding proportional and progressive taxation.
Relative Merits of Proportional Taxes:
- Proportional taxation leaves the tax payer in the same relative economic status.
- Proportional taxation is simple to calculate and to administer. Since it is uniformly levied, it is very convenient to estimate.
- Proportional taxation in not as repugnant to tax payers as progressive taxation.
- The effect on willingness to work hard and save is not adverse in the case of proportional taxes.
Relative Merits of Progressive Taxes:
- A proportional tax is inequitable, as it falls relatively heavily on poor incomes. A progressive tax is more equitable, as a larger part is taxed on higher incomes it is justifiable just as the law of diminishing marginal utility operates in the case of money. Hence, the disutility of paying a high tax by rich is not as much as that of poor in paying even a low tax. Therefore, the rich should be taxed at a higher rate than the poor.
- Progressive taxes may be justified on the ground that higher incomes contain surpluses, which have cent per cent capacity to bear taxes. Thus, progressive taxation fully complies with the principle of capacity to bear or ability to pay the tax.
- Progressive taxes are more economical, as the cost of collection does not rise when the rate of tax increases.
- Progressive taxation has greater revenue productivity than proportional taxation.
- The progressive tax system also complies with the canon of elasticity. For, a rise in income is automatically taxed at a higher rate under the system so that revenue increases with economic expansion.
- Progressive taxes are an engine of social improvement. The strong should assist the weak and the rich should aid the poor. This social morale is well sustained by progressive taxation.
- Progressive taxation can lead to a better distribution of income and wealth, hence, an increase in general welfare of the community. According to Kaldor, the desire to reduce economic inequalities can be regarded as a justification for adopting a highly progressive tax system.