Direct taxes can also be classified on the basis of the degree of progression or distribution of their burden on the tax-payers. A progressive tax is defined as one in which the ratio of tax to income rises with income.
A tax is called progressive when, with the increasing income the tax liability not only increases in absolute terms, but it also increases as a proportion of the income.
A proportional tax is defined as one whose rate of the tax is the same whatever the size of income is. In this case the tax liability increases in the same proportion as the increase in the tax-payer’s income.
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If the tax liability as a proportion of income falls with the increase in tax-payer’s income, it is termed as regressive tax. These can also be shown diagrammatically as in figure given below.
Proportional Tax:
As can be seen, in the proportional tax system, all incomes are taxed at a single uniform rate and it does not matter if the tax-payer’s income is high or low. The main advantage of proportional tax is that tax-payers can easily and quickly calculate the amount of tax they have to pay to the government.
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This tax is neutral with respect to income and wealth distribution and consequently it involves no structural change in the socio-economic set up of the society. The main disadvantage of proportional tax system is that the burden of tax falls more heavily on the poorer sections of the society.
Consequently, the proportional tax system does not satisfy the important canon of equity and justice in taxation.
Progressive Tax:
The rate of tax increases with the increase in income. A minimum exemption limit is fixed under a progressive tax. Above this limit, the higher income group tax-payers are taxed at progressive rates. Progressive taxation has become popular in all countries of the world today. The main advantages of progressive taxation are:
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(i) Progressive tax is based on ‘ability to pay’ principle. Since the ability to pay increases indirect proportion to the increase in income, the rate of tax goes on increasing with every increase in the size of income.
(ii) Progressive tax promotes equality of incomes and wealth because under it the richer persons are required to pay the tax at higher rate than the poorer persons. This tax system is more productive, economical and elastic.
The main disadvantages of progressive taxation are:
(i) It reduces capital formation because it is the rich who can save and, therefore, if they are taxed more heavily than the poor, the saving potential will either be lost completely or reduced substantially. Consequently, the process of capital formation is adversely affected as a result of progressive taxation.
(ii) A progressive tax offers great temptation and there is scope for tax evasion and tax avoidance. The tax-payers invariably try to evade the payment of the tax by presenting false statements of accounts before the taxing authorities and also avoid payment of taxes by finding legal loopholes in the tax provisions.
Regressive Tax:
In regressive taxation, higher the income of a tax-payer, smaller is the proportion of his income which he contributes to the government in terms of tax. Thus, a regressive tax is just the opposite of the progressive tax. Under this system of taxation, the poorer sections of society are taxed at higher rates than the richer sections.
As the income of an individual increases, the rate of tax diminishes. No country in the world has a regressive income and corporate tax system. It is only the indirect taxes like the sales tax that are regressive in nature.