There are three types of tax systems: progressive, proportional and regressive.
Direct and Indirect Taxes
Types of Tax Systems
A marginal tax rate is the extra tax for an additional dollar earned. The average tax rate is the ratio of the total tax paid over the total income earned.
1. Progressive Tax System
In a progressive tax rate system, higher income individuals pay a higher proportion of tax with a rise in income. In this case, the marginal tax rate would be higher than the average tax rate. A progressive ta is cited as a method to reduce inequality in society. Most economies around the world use a progressive tax to assess taxes for individual income.
2. Proportional Tax System
In a proportional tax rate system, everyone pays the same proportion of his or her income as tax. The tax rate does not change with an increase or decrease in income. Here, the average tax rate is equal to the marginal tax rate. This system exists in Latvia and Russia, and is considered to be more ‘fair’ and easier to manage for everyone. Some states in the U.S. like Colorado, Utah and Michigan impose a proportional income tax for individuals.
3. Regressive Tax System
A regressive tax is a tax which results in a decrease in the tax rate as the amount subject to taxation increases. In a regressive tax rate system, the individuals with lower income pay a higher proportion of his or her income as tax. Here, the marginal tax rate is lower than the average tax rate. Any tax with a cap above which no taxes are paid are regressive taxes.