Regressive Tax

What Is A Regressive Tax?

The Regressive Tax System is one of the taxation systems that applies a larger percentage of tax on lower-income earners than on high-income earners.

The structure results in a higher tax burden for the former. Regressive taxes are often considered unfair and inefficient. This may be because they do not follow the ability-to-pay principle and may increase income inequality.

The United States uses a range of regressive taxes. Consider sales taxes, for example. They are levied on goods and services purchased by people. This tax is the same for all incomes.

Excise taxes are fixed taxes imposed on specific products, such as gasoline, alcohol, and tobacco. Property taxes are a tax imposed on people's properties. Payroll taxes are deducted from wages to fund government programs.

Regressive taxes have some advantages and disadvantages. They are easy to administer and collect. This is because they do not require complex calculations or reporting.

They also provide a stable source of revenue for the government since they do not depend on economic fluctuations or tax evasion. However, they reduce the disposable income and purchasing power of poorer families.

This may affect their living standards and consumption patterns. It also creates disincentives for saving and investing because it lowers the after-tax return on capital. It may also negatively affect social welfare and economic growth because it increases wealth disparity.

Regressive taxes are often contrasted with progressive taxes and proportional taxes. Progressive taxes increase with income. In this format, wealthier families pay a greater tax rate than their poorer counterparts.

Proportional taxes apply the same percentage of tax to all income levels. In this structure, everyone pays the same proportion of their income in tax.

Both progressive and proportional taxes are more aligned with the ability to pay principle than regressive taxes, as they consider the differences in income among taxpayers.

Types of Regressive Taxes

Regressive taxes take a larger percentage of income from poorer families than from wealthier families. They are applied uniformly to all people. Regressive taxes are often criticized for being unfair and burdening the poor more.

Some common examples of regressive taxes are:

1. Consumption taxes

These taxes are imposed on our purchases. Consumption taxes are regressive. While every household may consume the same amount, consumption takes up a greater percentage of poorer families' income.

For example, consider an item that costs a hundred dollars. It would incur a ten-dollar tax if the tax rate was ten percent. However, the same ten dollars is worth more to someone who is poor. This is because it takes up more of their income.

2. Gasoline tax

This is a type of excise tax that is imposed on fuel purchases. The gasoline tax is regressive because poorer families tend to drive older and less fuel-efficient vehicles than wealthier families.

For example, if people drive the same distance and purchase gasoline with the same per gallon gas tax, they both pay the same dollar amount in tax. However, money is valued more by people who have less wealth.

3. Payroll tax

This type of tax is deducted from employees' wages to fund government programs. Payroll tax is regressive because it has a cap on taxable income. This implies that wealthier families may end up paying the same amount in tax as poorer individuals.

However, this will affect them differently because the same amount is more valuable to poorer individuals. As a result, this is also regressive.

Different Types of Tax Systems

The payment of a regressive tax can be traced back to every time you've made a purchase at a retail store or have fueled up your automobile. A regressive tax lacks consideration for income and is collected at an equal dollar amount or rate for people in different earning brackets.

The impact of this tax is much more profound and troublesome for those who earn less money because it constitutes a greater percentage of their total income compared to the affluent, who can spare the same dollar amount or rate without breaking a sweat.

Progressive, proportional, and regressive categorize tax systems.

1. Regressive Taxes

Low earners can find it more challenging to pay the same percentage of their income as higher earners when purchasing goods or products because of a regressive tax system. This type of tax is known for disproportionately affecting those with less income.

2. Proportional Taxes

Regardless of whether you are making $700 or $5 million a week, the proportional tax system means all individuals are taxed equally. Consider a flat income tax of 20%. This means that the government collects 20% of everyone's income.

3. Progressive Taxes

Operating on the theory that higher earners can bear more, a progressive tax system levies a larger percentage of taxation on them. Consider the following graduated income tax system. It may apply a 10% tax to incomes up to $50,000.

This goes up to 15% for incomes falling between $50,000 and $100,000. And finally, it rises to 20% for incomes that surpass $100,000. Despite being considered fair and redistributive, this tax system could foster disincentives for investment and work.

What is a progressive tax system?

Tax rates increase as income increases in a progressive tax system. Those with more resources must contribute more to public services that benefit all. This is due to the principle of ability to pay.

On the plus side, a progressive taxation approach presents benefits and drawbacks. One of the advantages is easing the tax liability for those with smaller incomes, who might find it challenging to afford basic necessities.

Conversely, a progressive tax system yields higher revenue from individuals with higher salaries, allowing them to contribute more without negatively impacting their standard of living. This extra income can contribute to public goods and services.

This may benefit amenities that enhance citizens' quality of life. The increased taxation will yield benefits for all citizens, not just those who pay those specific taxes.

Punishing those who earn a lot can discourage their drive to succeed and stifle economic progress. Tax evasion may become a viable option for those hit hard by a progressive tax system.

The richest population will do whatever it takes to protect their wealth from taxation. They may try to reduce their taxable income to do so. Ultimately, the system may disincentivize good practices, such as investing, saving, or starting new businesses.

This directly contrasts with their ambitions, which require them to work hard and achieve greatness.

Throughout the globe, different types of taxation systems exist beyond the traditional progressive tax system. Less commonly used are regressive taxes, which lower tax rates for high earners.

Then there's a flat tax, which uncaringly charges everyone the same tax rate regardless of their income bracket. Meanwhile, proportional tax considers each taxpayer's earnings and requires everyone to pay the same tax percentage.

Countries That Use Regressive Tax Structures

Public services and programs in different countries are funded through various tax methods. The usage of regressive taxes varies among countries. Below are some illustrations:

United States

The United States has a progressive tax system that aims to achieve equality. However, disparities exist in imposing taxes at the state and local levels, as many regressive taxes are still imposed.

A recent study in America showed that the poorest 20% faced an average rate of 20.9%. Meanwhile, the top 1% paid less than half at 7.4%. Additionally, nearly forty-five states have a slightly regressive tax structure.

Japan

In Japan, consumers face one of the world's highest consumption taxes. The tax rate was raised recently despite concerns about economic growth and inequality.

The consumption tax currently provides approximately 40% of Japan's overall tax revenue, compared to income taxes which account for roughly 30%.

Saudi Arabia

Saudi Arabia's failure to collect income tax has set it apart from other countries. Saudi Arabia utilizes oil revenues and other non-tax revenue streams for its government spending.

However, a 5% value-added tax was recently integrated in 2022, which functions as a regression tax on goods and services sold in the country.

Saudi Arabia's fiscal reform plan included implementing a value-added tax to decrease reliance on oil and expand the economy. This tax is so significant that its effects are visible in the country's GDP.

At times, seemingly impartial treatment of regressive taxes may appeal since they're indifferent to income. But they also possess adverse effects that could hurt you:

Regressive taxes especially hard hit poorer families compared to wealthier families. This is because their disposable income is reduced more. This can result in less money for basic necessities or savings after paying taxes.

Regressive taxes may widen the gap between the rich and the poor, ultimately increasing income inequality. This, in turn, causes various social problems. Poverty, crime, and political instability are only some of the potential consequences.

Regressive taxes can reduce consumers' purchasing power, which may reduce economic activity and consumption. Consequently, businesses, growth, and employment may be negatively impacted.

Pros and Cons of a Regressive Tax System

Regressive taxes have both advantages and disadvantages for the economy and society. Some of the advantages are:

1. Easy to administer and collect: They do not require complex calculations or reporting by the taxpayers or the tax authorities. They also reduce tax evasion and avoidance opportunities, as they are levied at the point of sale or consumption.
2. Encourages economic growth and efficiency: They do not distort the incentives to work, save, invest, or consume, as they do not vary with income levels. They also do not create deadweight losses, which are the losses in economic surplus due to taxation.
3. Used to correct externalities and promote social goals: Externalities are the costs or benefits that affect third parties who are not involved in economic activity. For example, tobacco taxes can be used to deter smoking.
   • This can improve public health and preserve the environment. Similarly, gasoline taxes can reduce pollution and congestion caused by driving.

Some of the disadvantages of regressive taxes are:

1. Unfair and inequitable: They hurt the poor more than the rich, violating the principle of vertical equity. Vertical equity states that taxpayers with more ability to pay should pay more taxes than those without.
   • Regressive taxes also violate the principle of horizontal equity, which states that taxpayers with a similar ability to pay should pay similar amounts of taxes. Regressive taxes create disparities among taxpayers with different consumption patterns or preferences.
2. Can increase poverty and inequality: They reduce the disposable income and purchasing power of poorer families, affecting their living standards and well-being. They also increase income inequality. This can have negative social and political consequences.
3. Can reduce government revenue and fiscal stability: They depend on the level of economic activity and consumption. Because these values can fluctuate with business cycles and consumer confidence, this is an unstable source of income for the government.
   • They also tend to be less elastic than progressive taxes. This means that they do not respond proportionally to changes in income levels. 

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Current Debt
• Current Liabilities
• Earnings Before Tax
• Tax Depreciation
• Temporary Account