Question

3. Many years ago, there were calls to simplify federal personal income tax code. One proposal was a flat tax. Under this proposal, each individual is allowed a standard deduction of, say, $20,000, and each family is allowed a standard deduction of $40,000. No other exemptions and deductions are allowed. The remaining income is subject to one flat tax rate of say, 20%. (2 Point) Please analyze the vertical equity of a flat tax designed like this, from both marginal tax rate and average tax rate perspectives. Is it a progressive, proportional, or regressive tax?

Answer 1

What is Vertical Equity

Vertical equity is a method of collecting income tax in which the taxes paid increase with the amount of earned income. The driving principle behind vertical equity is that those who have the ability to pay more taxes should contribute more than those who are not.

The average tax rate is the total amount of tax divided by total income. For example, if a household has a total income of $100,000 and pays taxes of $15,000, the household’s average tax rate is 15 percent. The marginal tax rate is the incremental tax paid on incremental income. If a household were to earn an additional $10,000 in wages on which they paid $1,530 of payroll tax and $1,500 of income tax, the household’s marginal tax rate would be 30.3 percent.

Average tax rates are a measure of a household’s tax burden; that is, how taxes affect the household’s ability to consume today or (through saving) in the future. Marginal rates measure the degree to which taxes affect household (or business) economic incentives such as whether to work more, save more, accept more risk in investment portfolios, or change what they buy. Higher marginal rates reduce incentives to engage in a particular activity (such as work) or (in the case of sales taxes) consume a particular item.

It is progressive tax

Progressive income tax. This is the system that we have now. A progressive income tax is exactly what it sounds like: the rate of tax increases as income (however measured) increases. Technically, you can create a progressive income tax system even when stated tax rates remain flat by using personal exemptions, tax credits and tax deductions to alter the effective tax rate. Although our current system isn’t very popular at home, it’s perhaps the most common tax system used in developed countries around the world. Countries that use a progressive income tax system include China, Japan, Australia, France, Germany, Italy, Canada and the United Kingdom.

• People like a progressive tax because it raises revenue by taxing those who can most afford to pay. Offering tax breaks for those at the bottom should, in theory, give those taxpayers the opportunity to increase their wealth and work their way out of poverty. And, of course, progressive tax should encourage the distribution of wealth, making it less likely that dynasties would concentrate their wealth as they did in pre-Revolutionary War England.
• People don’t like a progressive tax because it treats people differently: those at the top are charged with paying more, as a percentage of income, than those at the bottom. While it’s true that some taxpayers – like Warren Buffett – pay a lower effective tax rate than many in the middle class, the U.S. still has one of the most progressive systems in the world, collecting the largest share of taxes from those at the top. According to the Tax Foundation, the top 1% of taxpayers have consistently paid more in federal income taxes than the bottom 90% since 2003 and that share has increased almost every year since 1980 (beginning with President Reagan’s tax reform efforts). This is true even when paying more in taxes does not necessarily result in increased services. Progressive taxes are also considered more complicated than other forms of tax (just look at the length of our existing Tax Code).