Three Types of Tax Systems

Three Types of Tax Systems

Reviewed by Raphael Zeder | Updated Oct 30, 2019

Taxes are one of the most controversial topics in economics. While most people agree that they are necessary, there is a lot of disagreement over how the tax burden should be distributed across the population. Nowadays, most taxes are designed according to what we call the ability-to-pay principle. This principle states that taxes should be levied on people according to how well they can carry the burden. Simply put, the more money people have, the more taxes they should pay. Starting from there, we can identify three types of tax systems, depending on how quickly the tax rate rises (i.e., how more people have to pay) as income increases. Namely, the three types are (1) proportional taxes, (2) regressive taxes, and (3) progressive taxes.

1) Proportional Taxes

Proportional taxes require all taxpayers to pay the same fraction of their income, regardless of how much money they earn. That means the tax rate doesn’t change as income increases (or decreases). Therefore, this system is also commonly referred to as a flat tax.

For example, let’s say we have three friends: John, Jake, and Richard. John earns USD 50’000 per year, whereas Jake’s annual salary is USD 100,000. Meanwhile, the highest earner of the group is Richard, with a yearly salary of USD 200,000. Now the government introduces a proportional income tax that requires all taxpayers to pay 20% of their income. The table below illustrates this.

NameIncome (in USD)Tax Rate (in %)Tax Burden (in USD)
John50,0002010,000
Jake100,0002020,000
Richard200,0002040,000

As you can see, the tax rate doesn’t change, regardless of the level of income. John, Jake, and Richard all have to pay 20% of their annual income. Please note that because of the different levels of income, Richard still ends up paying more than the other two, and Jake still pays more than John.

2) Regressive Taxes

Regressive taxes require high-income taxpayers to pay a smaller fraction of their income than low-income taxpayers. That means as income rises, the tax rate decreases. Now, in reality, we hardly ever see this tax system when it comes to income or wealth taxes. Instead, we see regressive taxes whenever taxes are levied directly on products or services that people buy (e.g., sales tax). In this case, the tax remains the same, regardless of the buyer’s income or wealth (i.e., it is not correlated to either of them). As a result, as income rises, the fraction of income devoted to the tax decreases.

To illustrate this, let’s say that John, Jake, and Richard all buy a new truck worth USD 50,000. For the sake of this example, we’ll assume that sales taxes are precisely 10%. That means each of our friends has to pay USD 5,000 in sales taxes. Now, with this information, we can calculate an effective tax rate in relation to their income, as shown in the table below.

NameIncome (in USD)Tax Rate (in %)Tax Burden (in USD)
John50,000105,000
Jake100,00055,000
Richard200,0002.55,000

As you can see, John has to pay 10% of his annual income to clear the sales tax. By contrast, Jake and Richard only have to pay 5% and 2.5% respectively to clear the tax. In other words, the USD 5,000 tax makes up 10% of John’s income but only 2.5% of Richard’s income.

3) Progressive Taxes

Progressive taxes require high-income taxpayers to pay a larger fraction of their income than low-income taxpayers. That means, as income rises, the tax rate increases as well. This tax system is designed to affect higher earners more than people with a low income (see also marginal vs. average tax rate). Essentially, the idea behind this is that upper-class people can afford to pay more because they are richer than middle- or lower-class people. Nowadays, this is one of the most commonly used tax systems.

Let’s revisit our example from the beginning. Now instead of a proportional tax, assume the government introduces a progressive income tax. This new system has three tax brackets: (1) People who earn up to USD 50,000 pay a 5% income tax, (2) people who earn between USD 50,000 and USD 100,000 pay 10%, and (3) people who make more than USD 100,000 pay a 20% income tax. That places John, Jake, and Richard in three different brackets.

NameIncome (in USD)Tax Rate (in %)Tax Burden (in USD)
John50,0002,500
Jake100,00010 10,000
Richard200,00020 40,000

Now John only has to pay USD 2,500 in taxes, whereas Jake and Richard have to pay USD 10,000 and USD 40,000, respectively. However, despite the higher tax rate, Richard still has a lot more money (USD 160,000) in his bank than does John (USD 47,500). Therefore, the higher tax burden does not affect him as much as the others because he can afford to pay more and still have a higher disposable income.

In a Nutshell

While most people agree that taxes are necessary, there is a lot of disagreement over how the burden should be distributed across the population. Nowadays, most taxes are designed according to the ability-to-pay principle, which states that taxes should be levied on people according to how well they can carry the burden. Starting from there, we can identify three types of tax systems: proportional, regressive, and progressive taxes. Proportional taxes require all taxpayers to pay the same fraction of their income, regardless of how much money they earn. By contrast, regressive taxes require high-income taxpayers to pay a smaller fraction of their income than low-income taxpayers. And finally, progressive taxes require high-income taxpayers to pay a larger fraction of their income than low-income taxpayers.

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