Policy Instrument:
Definition
A progressive tax system is one in which individuals and entities with higher income and more wealth pay more taxes than those who have less. More formally, a tax system may be defined as progressive if after-tax income is more equitably distributed than pre-tax income. Usually this comparison is done in relative terms, typically by comparing the income shares of the bottom and top percentiles before and after taxation, or by comparing distributional indicators, such as the Gini index or the Palma ratio, estimated on pre-tax income and on post-tax income. Dedicated indices of progressivity of tax systems, such as the Kakwani Index (which builds upon Gini to make a synthetic indicator of progressivity) are also commonly used to assess the degree of redistribution achieved.
Rationale
Progressive taxation is a foundational mechanism through which governments reduce economic inequality and mobilise domestic resources for investment in public goods and social protection. By ensuring that the tax burden is distributed in proportion to contributory capacity, progressive fiscal systems help to narrow income and wealth disparities and to finance universal public services, strengthening the social contract between the state and its citizens.
Key Interventions
A combination of different taxes is typically employed to achieve overall fiscal progressivity, with progressive personal income taxes, as well as corporate and wealth taxes remaining the cornerstone of every progressive tax system. The following types of taxes are common in tax systems around the world, and they are listed from more progressive to most regressive:
- Progressive personal income taxes: Applied to individual earnings. Higher income brackets are subject to higher marginal rates.
- Corporate taxes: Levies on business profits, including taxes on the financial sector.
- Wealth taxes: Charges on accumulated assets, including property taxes and inheritance taxes.
- Natural resource extraction taxes: Revenues collected from the exploitation of natural resources.
- Innovative taxes: Including sin taxes (applied to alcohol, tobacco, and sugar-sweetened beverages), airport and hotel levies, arms taxes, and carbon taxes.
- Tariffs: Import and export duties applied at national borders.
- Consumption and value added taxes (VAT) and tolls: Typically the most regressive instruments, as lower-income households bear a relatively higher burden.
Indirect taxes, such as consumption taxes and tolls, are often the most regressive because consumption does not rise proportionally on income. For instance, a poor and a rich adult at the same age and sex may have similar caloric intake necessities and, even though the richer buys more expensive food, this is not likely to compensate how much richer he is. Therefore, a way to mitigate the regressive aspect of indirect taxes is setting up cashback schemes that return a portion of tax expenditures or of certain consumption costs to those worse-off.
Cashback systems function as targeted financial rebates or credits that help offset the costs of essential goods and services, effectively relieving the burden on those who are most affected by consumption taxes. The rate of the rebate or credits returned can also be differentiated to decrease in the opposite direction of the income increase, enhancing even more the progressiveness of a tax system.
Low-income households
Tax reforms aimed at implementing progressive taxation require a politically sustainable social contract and a strong political will.
In considering tax reforms, a number of important issues need closer and rigorous examination:
- Efficiency: New taxes or higher tax rates must not affect resource allocation or economic efficiency adversely to any significant extent. Taxes do impose real economic costs, and all countries should seek to minimize such “deadweight losses,” which reduce the resources available to achieve socially desired objectives.
- Fairness or distributional impact: That is, burden of tax should not fall excessively on the poor or low-income households. A standard approach to distributional effects to assess the ‘progressivity’ or ‘regressivity’ of a tax: A tax is considered progressive if the tax burden increases as income increases, and regressive if the burden decreases with income. In addition, the gender aspect of distributional impact needs to be considered. The tax system should not put female taxpayers at a disadvantage.
- Compliance: Cost that taxpayers incur in meeting their tax obligations, over and above the actual payment of tax. Third parties also incur compliance costs. For example, employers may withhold income taxes from employees, and banks may provide taxing authorities information or may collect and remit taxes to government. Compliance costs include the financial and time costs of complying with the tax law, such as acquiring the knowledge and information needed to do so, setting up required accounting systems, obtaining and transmitting the required data, and payments to professional advisors. Any tax reform must try to minimize compliance cost.
- Administrative feasibility and cost: Regardless of what a particular country may want to do with its tax system, or what it should do with respect to taxation from one perspective or another, it is always constrained by what it can do. Tax policy choices are influenced by a country’s economic structure and its administrative capacity. These factors reduce the tax policy options available to developing countries, especially the low-income countries. Therefore, development partners should consider enhanced technical support for these countries in tax matters.
In addition to national efforts, there is a need to level the playing field in terms of taxes on corporations, by introducing an internationally agreed minimum corporate income tax rate to bring an end to the race to the bottom of tax concessions to corporations, which have only resulted in lower tax proceedings. Ongoing discussion at the United Nations are aiming at a United Nations Tax Convention establishing a minimum corporate income tax rate.
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