Understanding the Progressive Tax Code

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  • 0:05 Progressive Tax Code
  • 1:06 The History
  • 2:43 Effects
  • 4:52 Differences in Codes
  • 5:38 Progressive Tax Code
  • 10:12 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

In this lesson, learn what a progressive tax code is, how to recognize it, and what the alternatives are. Then, learn the differences between the three tax codes: progressive, regressive and proportional. Finally, learn how sales tax would impact progressivity.

Understanding the Progressive Tax Code

At the First National Bank of Ceelo, Lydia the factory worker (who's recently been laid off) is standing in line at the teller window waiting to cash her unemployment check. Lydia will earn a total of $20,000 of income this year. Joe the plumber remodels kitchens and bathrooms for a living and had a great year last year, but the economy has slowed down this year, and he'll earn a total of $30,000 of income. Joe's standing in line behind Lydia today at the bank, while Dave (the manager) looks through the glass window of his office that faces the lobby. This year, Dave will end up earning a total of $50,000 in income. Each one of them will owe personal income taxes for the year, but the percentages they'll pay in taxes are not the same. In this lesson, you'll find out why. You'll also learn how to recognize a progressive tax code, what effects it creates and what the alternatives are.

History of the Progressive Tax Code

The progressive nature of the federal tax code began in the United States in 1913, although it can be traced back to the Revenue Act of 1862, which was signed into law by President Abraham Lincoln. In 1913, the tax on individuals earning $3,000 or more was one percent, while it was seven percent for individuals earning at least $500,000 per year. This idea spread around the world, and now we find that most countries have a progressive tax code.

A progressive tax code means that people who earn higher income pay more taxes. For example, if an individual earning $50,000 pays a 15% marginal tax rate, while someone earning $100,000 pays a 28% marginal tax rate, this is a progressive tax code.

Progressive tax codes consist of marginal tax rates. The marginal tax rate is the amount of tax paid on every additional dollar of income earned. For example, suppose I am currently paying a 15% tax rate when my income is $50,000, but suppose I pay a 20% tax rate on anything I earn above $50,000. That means an additional dollar of income is taxed at a marginal rate that is higher. On the other hand, if you take the total income tax owed divided by the total income earned, this gives you what we call average tax rate.

Effects of a Progressive Tax Code

So, why do marginal tax rates matter in economics? Economists recognize that individuals' decisions about how much to work are made based on how high the marginal tax rate is as opposed to the average tax rate. The marginal rates create incentives and disincentives to work, which can have a huge effect on economic growth, especially if people who earn a ton of money also pay a majority of the taxes in the nation.

The major effect of a progressive tax code is that an economic disincentive is created for individuals to earn extra money if the next dollar will be taxed more than the last dollar. Throughout history, leaders have debated which style of taxation is most effective and changed the marginal tax rates many times in an effort to strike a balance between sharing the burden of paying taxes equally and avoiding the economic disincentive that is created when tax rates on income are too high. In other words, people have less of an incentive to work harder if they know they'll have to pay higher taxes on extra income. For example, the highest tax rate paid by high-income earners in the last half-century was, believe it or not, an income tax rate of 91% in 1963! Can you believe that? I don't know about you, but if I'm working hard and I earn $50 million this year (I love the sound of that!) and the federal government required me to hand over $45.5 million of it, I would definitely have less of an incentive to work hard the next year!

Here's what famous economist Adam Smith, sometimes referred to as 'the father of economics,' had to say about the idea of a progressive tax code: 'in this sort of inequality there would not, perhaps, be anything very unreasonable. It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.'

Progressive, Regressive and Proportional

There are basically three ways to explain the tax code that quickly tell us how wealth is getting redistributed in a nation: progressive, regressive and proportional. When the average tax rate is higher for people with more income, we say the tax code is progressive. On the other hand, when the average tax rate is lower for people with more income, we say the tax code is regressive (this is the opposite of progressive). Finally, if the average tax rate is exactly the same for people with low incomes as it is for people with high incomes, we say the tax code is proportional.

How to Recognize a Progressive Tax Code

Let's walk through an example, step by step. Here is a list of three tax plans: plan A, plan B and plan C. What we want to find out is, out of these three tax codes, which is the most progressive?

So, as you can see, we have a chart of three different levels of income. Think of these as three different people in the economy - suppose it's Lydia the factory worker, Joe the Plumber and Dave the bank manager. The way we answer this question is by calculating the average tax rate for each level of income under each plan. These are the tax amounts we can see here, but we need the average tax rates, so we can compare apples to apples and see what the patterns of these tax plans are - whether they are progressive, regressive or proportional.

Plan A is a proportional tax code.
Proportional Tax Code

First let's look at plan A. Under plan A, Lydia pays $2,000 of her $20,000 income - well that's a ten percent average tax rate. Joe pays $3,000 of his $30,000 earnings, which is, again, a ten percent average tax rate. While Dave pays $5,000 of his $50,000 income, which, once again, is a ten percent average tax rate. So now we can conclude that plan A is a proportional tax code, because everyone pays the same proportion of their income.

Plan B is a progressive tax code.
Tax Code Plan B

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