According to Google, a tax is: 

"a compulsory contribution to state revenue, levied by the government on workers' income and business profits or added to the cost of some goods, services, and transactions."

This definition covers a wide variety of things the government can do and call a tax. The government could decide that sodas are bad and need to be taxed. Or yachts. (hint: both of these things have already happened) Taxes can be tricky, though, because they frequently have unintended consequences. See, one of the most basic precepts of economics is that people respond to incentives (which can be positive or negative). 

In the case of the yacht tax, people just stopped buying yachts! When George H. W. Bush passed ten percent luxury tax on yachts, luxury airplanes, jewelry, furs and expensive cars, many viewed it as a harmless way to collect extra tax revenue from ultra-wealthy individuals. However, the people buying these luxury goods didn't exactly need them to survive, and when the price went up 10% overnight, they decided to drop out of the market.

"Pish posh", you say, "who cares that these rich people aren't getting their boats and furs?" Well, the hundreds of thousands of workers making these items cared. 

"In the first year [of the tax], one-third of all yacht building companies in the U.S. stopped production, and according to a Congressional Joint Economic Committee, the industry lost 7,600 jobs. Before it was over, 25,000 workers had lost their jobs building yachts, and 75,000 more jobs were lost from the indirect effect on companies supplying parts and materials to the yacht companies."

The tax ended up making the government negative money, because so many people lost their jobs. The boating industry has permanently moved out of the US, and despite the tax's rapid repeal, has never returned. This is a harsh example, but given the financial burden taxes represent, governments must thoroughly examine the way they will affect people. 

How can taxes affect people of different income levels? 

The way a tax affects you (or your friend in a different tax bracket) depends on its structure. 

A progressive tax increases in size as income increases. The US system of income taxes is a progressive tax system - as you make more money, you are taxed increasingly high percentages of your income. 

A flat tax is the same for all people in terms of proportion, not dollar amount. For example - everyone is taxed 10% of their income. A flat tax would not be requiring everyone to pay $1000, for example. That would be a regressive tax.

A regressive tax increases in size as income decreases. Any kind of flat fee tax, such as the $1000 dollar example above, would be regressive. This is because for someone with a $100,000 income, a $1,000 tax turns out to be a 1% tax. On the other hand, for someone making $20,000 a year, a $1,000 tax is a 5% tax. So as income decreases, the proportion of income the tax takes up increases. This can be a tricky concept to understand, so let me explain further.

Sin taxes are a great example of a regressive tax. A sin tax is an increase in the price of items such as liquor, cigarettes, lottery tickets, and more. You can get an idea of what they were originally used for - to discourage people from partaking in "sinful" activities / purchases, while generating revenue for the state/country/whatever. The term "sin tax" is used to describe the sinful connotations of the goods they typically cover, but the lines have become a bit blurred as the definition has expanded to include candies, junk food, and soft drinks. A sin tax is actually just a cute name for an excise tax - a tax applied upon some but not all goods. In this way it is different from a sales tax, which is flatly applied across all goods.

Semantics aside, the sin tax seems like a great idea, but ends up being regressive in nature. People of lower incomes are more likely to be smokers and buy more lottery tickets, for one. So sin taxes end up being more heavily directed towards lower incomes from the get-go. Sin taxes are also regressive because they are a flat amount (not percentage) taxed on an item, and therefore cost more for low-income individuals, as the dollar amount represents a greater proportion of their income. For example,

Imagine a wealthy smoker (let's call her Wendy) , $100,000 income, buys 100 packs a year. A sin tax of $2 is added to the cost of cigarettes. This will cost Wendy $200 a year, and represents 0.2% of her income. This is a small price to pay for a habit Wendy really likes. 

On the other hand, there is low-income smoker (Ben), $15,000 income, buys 100 packs a year. Ben will also have to pay $200 extra, but this represents 1.33% of his income. Ben struggles to make ends meet, and cannot afford to keep buying cigarettes at this price.

While the sin tax was the same dollar cost for both Wendy and Ben, it will affect the low-income person (Ben) more. Thus, it is regressive. Sin taxes are fairly common, especially on cigarettes and lottery tickets/gambling. 

Taxes can be challenging, as they inherently represent a negative incentive (no one likes giving up their money!). The government needs tax revenue to survive (and to pay the interest payments on our national debt), while creating taxes can discourage people from opening businesses or keeping their corporation in the United States. Ideally, with tax revenue society can improve as a whole, and income distribution can be a bit more equitable. 

On a final note, let's re-examine the name "progressive tax". In my mind (and according to Google's definitions), something "progressive" is either "developing gradually in stages" OR "implementing social reform or new, liberal ideas". The latter definition is much more amusing to apply to a tax, as it brings to mind images of a Northern-Californian eating granola and weaving hemp fibers. One might even claim that sin taxes aim to "implement social reform". In light of this, perhaps we should re-name "sin taxes" as "progressive taxes", and call "progressive taxes" just "taxes". Any opposition?

In Short

There are lots of kinds of taxes, including regressive, progressive, sin, excise, sales, and flat taxes. Creating taxes can change people's incentives, and affect socioeconomic groups very differently. Policy-makers would be wise to consider the incentives their taxes will create. 

Posted
AuthorIsabel Munson