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Regressive vs. Progressive Taxes and Income Equality

Distinguish between regressive and progressive taxes and explain whether you would use an income tax or a specific indirect tax to make post-tax incomes more equal. [8]

Category:

Taxes and subsidies

CIE AS LEVEL JUNE 2019

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Answer


Tip: This essay is divided into two parts

Part (1) Distinguish between regressive and progressive taxes
Part (2) Explain whether you would use an income tax or a specific indirect tax to make post-tax incomes more equal.

Make sure to balance your essay in order to address both parts.



(Step 1: Define tax)



A tax is a levy or charge imposed by a government to raise costs of production and to reduce consumption of certain goods or services.



(Step 2: Define direct tax and indirect tax)



Two types of taxes are direct tax and indirect tax.

Direct taxes are paid directly to the government by taxpayers, either as individuals or companies, from their incomes. Income tax is an example of a direct tax.

Indirect taxes are collected for the government by retailers and local government bodies. Examples of indirect taxes include ad valorem taxes and specific taxes. A specific tax is levied as a fixed amount per unit while an ad valorem tax is the fixed percentage of prices.



(Step 3: Distinguish between progressive tax and regressive tax)



Both direct and indirect taxes can be classified as being progressive or regressive. The relationship between taxation and income varies for different types of tax.

Progressive taxes are those that when income rises, the proportion of the total paid in taxes increases; the average rate of taxation will therefore be lower than the marginal rate. Examples of progressive taxation are income tax, capital gains tax and stamp duty.

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As the level of income increases from Y1 to Y2, the rate of tax rises from T1 to T2


Regressive taxes are those that as income rises, the proportion of total income paid in tax falls.. For example, although a high-income earner pays the same amount of television licence fee as a less wealthy person, the amount of tax paid is a smaller proportion of the wealthier person's income.

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With a specific amount of tax paid, high income earners (those at y2) pay a smaller proportion of tax (t2) than low income earners (those on y1 who pay T1)

In summary, for a progressive tax, the fraction of income paid as taxes increases as income increases for there is an increasing tax rate whereas in regressive taxation: as income increases, the fraction of income paid as taxes decreases due to the decreasing tax rate.



(Step 4: explain how to use specific indirect tax to make post-tax incomes more equal.)



A specific indirect tax is believed to have a regressive effect on post-tax income. A specific tax is a fixed amount of tax placed on a particular good. It is also referred to as a per-unit tax, and the tax will depend on the quantity sold (not price).

For example, imagine two individuals each purchase $100 of clothing per week, and they each pay $7 in tax on their retail purchases. The first individual(A) earns $2,000 per week, making the sales tax rate on her purchase 0.35% of income. In contrast, the other individual(B) earns $320 per week, making her clothing sales tax 2.2% of income. In this case, although the tax is the same in both cases, the person with the lower income(B) pays a higher percentage of income, making the tax regressive.

In other words a regressive tax reduces post-tax income of individual B by a larger percentage than that of individual A and hence it increases the difference in their post-tax incomes. Also, as income increases from $ 320 to $2000, the fraction of income paid on the indirect tax decreases. Hence it follows that a specific indirect tax is inconsistent with the objective of a more equal post-tax income.



(Step 5: explain how to use income tax to make post-tax incomes more equal.)


A personal income tax involves taxes paid by households or individuals on all forms of income, including wages, rental income, interest income and dividends. It is possible to make personal income tax progressive by increasing the tax rate along with increase in income.

For example, consider two individuals A and B with the annual income of $ 10000 and $20000 respectively. Now suppose the tax rate applicable to A's income bracket is 10% while it is 20% for individual B. Since the tax rate increases as income increases; as a result, the difference in their post-tax incomes now will be less than the difference in their pre-tax incomes. So, a progressive tax reduces the difference of post-tax income for it takes a larger proportion of higher income as tax than what it takes of lower income.




(Step 6: Conclude whether you would use an income tax or a specific indirect tax to make post-tax incomes more equal.)



So, with the view to make post tax income more equal, the government would rather use a progressive income tax than a specific indirect tax. This is because a specific indirect tax is believed to have a regressive effect on post-tax income whereas is possible to make personal income tax progressive by increasing the tax rate along with increase in income.




>MARKING SCHEME<

Distinguish between regressive and progressive taxes and
explain Whether you would use an income tax or a specific
indirect tax to make post-tax incomes more equal.
Knowledge and understanding:
For a definition of a regressive tax
For a definition of a progressive tax
1 mark
I mark
(KU: up to 2 marks)
Application :
Explains that specific indirect taxes are regressive (Up to 2 marks)
and their impact upon the equality of post-tax incomes (1 mark)
Explains that income taxes can be progressive (up to 2 marks)
and their impact upon the equality of post-tax incomes (1 mark)
(APP: up to 6 marks)


Candidates need to have a clear understanding of the
difference between a regressive and progressive tax
and that specific indirect taxes will be regressive and
income taxes can be designed to be progressive.



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