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Loosely defined, progressive tax is tax where the average rate of tax rises as income rises, that is, the proportion of your income taken in tax rises, as you becomes richer (Kuhn, 2011). Supporters of progressive taxes argue that such a scheme is equitable and that progressive taxation can and should be used to reallocate income within society so that the final distribution is more equal than the original one. However, data strongly suggests that the real income impacts of high marginal taxation of financial and intellectual capital have resulted in inferior real after-tax income for all (Hartman, 2001). It has been argued that targeting a tax towards the minority high incomers, however accepted this is with the majority of non high-income earners; few realize that many high income earners have the ability to pass the cost of progressive taxes to the lower income levels by means of price for goods or services (Kuhn, 2011).
Progressive taxation was planned to reduce income inequality by excessively taxing upper incomes and redistributing the proceeds through the welfare state (Hartman, 2001). The Great Depression and the Second World War resulted in extensive welfare policies and extremely progressive tax rates. Since the Progressive Era of the early 20th century, the existing insight has been that progressive taxation of wealth is an essential condition of social equity. This requires that the wealthy be taxed at increasing rates for increasing levels of income and resources (Hartman, 2001).
Hartman (2001) states that, “a dollar of salary income expended on consumption has a marginal rate equal to nominal. On the other hand, a dollar saved and invested in a corporation must pay personal tax in order to be invested, corporate income tax before a dividend can be paid and personal income on the dividend—a composite maximum marginal tax burden at 74.3 percent of the original income invested! Moreover, when inheritance tax is considered, only 11.6 cents of the original dollar earned now remains” (Hartman, 2001).
Progressive taxes when coupled with inflation and economic expansion, results in a disproportionate appreciation of tax revenues that have underwritten income distribution schemes without voter option (Hartman, 2001). According to a research study of IRS returns by Hartman (2001), over the period 1957–1971 the tax share paid by the top 10 percent was constant, and the after-tax income of the other 90 percent of income was relatively constant as well. However, starting 1973 top 10 percent income tax share began a worldly rise that continued through 1997, increasing from 48 percent to 63 percent. But contrary to the rationale of progressive taxation, the after-tax income of the other 90 percent started a matching secular decline from 72 percent to 59 percent.
Despite the increased tax burden carried by the top 10 percent and enormous expansion of welfare to redistribute the increased income taxes collected, the after-tax income of other 90 percent declined. The decline of the other 90 percent income share clearly was not due to a disproportionate increase in the growth rate of the top 10 percent income. It was due to historically substandard growth of the other 90 percent of incomes since progressivity of taxation resumed its secular increase (Hartman, 2001).
Given that increasing the share of taxes paid by the wealthy does not increase the after-tax income of the rest of the people, then serious reassessment of public policy is necessary (Diamond & Saez, 2011). Progressive taxation for income redistribution has achieved the opposite of its goals of helping persons of lesser means. Progressive taxation is an established failure that demands remedy by fundamental tax reform such as the idea that no tax shall have more than one rate, which shall be uniformly applicable to all taxpayers, and any deduction, exemption, or credit against a tax shall be equally valuable to all taxpayers. The result would be a return to the long-standing equity standard of civilized taxation through the principle of proportionality (Hartman, 2001)
Government dependency on a small group of people for the majority of tax revenue is very unstable as the progressive tax magnifies small fluctuations in the economy resulting in tax windfalls either either in good years or horrific tax deficits in bad years (Kuhn, 2011).
Models in optimal tax theory typically hypothesize that the tax system should capitalize on a social welfare function subject to a government budget constraint and taking into account that individuals respond to taxes and transfers. Social welfare is larger when resources are more equally distributed, but redistributive taxes and transfers can negatively affect incentives to work, save, and earn income in the first place (Diamond & Saez, 2011).