When political leaders discuss tax reform, they often refer to "progressive taxation." What does this term mean? What pros and cons does this type of tax structure offer today?

Toward a Concept of Income Fairness

When the United States government first implemented a system of taxation, economists soon observed a uniform tax rate would fall more heavily upon poor people than wealthy ones. Why? Just consider this example. If one household earns $100,000 and another earns $30,000 and both pay a flat tax of 10%, the wealthy family can still spend $90,000 after taxes. The family in poverty must somehow scrape by on $27,000 (equivalent to $500 per week).

Since both households must pay certain necessary expenses, such as food and housing, the low income earner will experience far greater tax hardship than the affluent earner. Congress attempted to ease the tax burden on poor families by creating a graduated system of "progressive" taxation, taking a higher percentage of income as affluence increases.

Advantages of Progressive Taxation

Supporters of progressive taxation point to several benefits. First, this system enables poor and middle class households to live more comfortably while still paying taxes, a process investing them in citizenship. Second, it enables the government to establish high upper tax brackets to generate revenue.

Third, a progressive taxation system potentially produces more total income for the government to use to fight deficits than a flat tax. Fourth, progressive taxation improves the spending power of lower-income earners, potentially stimulating free market economies more effectively than flat taxes.

Disadvantages of Progressive Taxation

Progressive taxation offers several disadvantages to the American people. The grading system has given way to hundreds of complex incentives, which drives the cost of compliance up to more than $215 billion (compared to the IRS’s conservative $20 billion estimate). Congress has created complex rules for tax credits and deductions. A tax credit enables a taxpayer to subtract a specific sum from taxes owed to the government. It differs from a "deduction", which simply reduces the amount of total income subject to taxation.

Another disadvantage of progressive taxation is the inherit inequity in the system. Many politicians have made their political careers on promising to make wealthy Americans pay their “fair share,” but few of these ideologues can give any kind of definition for what “fair” means. After all, a flat tax rate would still require the wealthy to pay more, but the same percentage of their annual income. Under the current system, 47% pay no taxes, whereas the highest effective tax rates on upper-middle class families can approach 50% in some states, resulting in a so-called representation without taxation. Although the progressive tax system was implemented with fairness and equity in mind, the result is arguably a tremendous injustice.

Tax Reform Issues

Whether someone agrees or disagrees with progressive taxation, this idea does carry significant weight in modern tax reform debates. Both progressive taxation and tax credits will likely capture media headlines during any Congressional overhaul of the Internal Revenue Code.

References:

Investopedia - Tax Credit

Investopedia - Progressive Tax