74. Explain how a progressive tax system may be used to redistribute income.

A progressive tax is a tax which increases as ones income increases. This is because the tax is a proportion of your income (this proportion is however not constant, which will be explained). This means that people with low income, who are generally less wealthy, pay less tax than people with higher income, who are generally wealthier. As income further increases beyond a certain point, one has to pay a higher percentage tax for the income beyond that point. This is what makes a progressive tax different from a proportional tax, in which the percentage tax is constant not depending on the amount of income you receive. The average percentage tax one has to pay therefore increases as income rises. Something to note about this is that one is not paying tax for the first part of ones income (say the first $10,000), because the percentage tax of the income under that limit is zero percent. Therefore, if your total income is under this limit, you are actually not paying any tax at all under a progressive tax system.

The tax one pays goes to the government, which in turn uses the money they receive to provide goods and services to the people and to firms, which can be seen in the circular flow model. This means that the total amount of tax a population pays as a whole essentially comes back to them. However, the return that one gets in the form of goods and services does not depend on the amount of tax one originally paid*. Therefore, the people who paid less tax benefit more from this more than the ones who pay more, because they all get the same return (they get the same for less). This results in a robin-hood kind of phenomenon (‘Take from the rich and give to the poor’), which results in the people with lower income to be relatively better off because of the redistribution of income that occurs.

Therefore, if a government would want to redistribute income, they should set the percentage tax of high incomes to be high, and the percentage tax of low incomes to be low, because what this essentially results in is the wealthy people sharing their incomes with the less wealthy.

*In some societies it is probably true that the government favors the wealthier people and therefore gives them more in return than the less wealthy, but I am assuming that this is not true.
external image effective-tax-rate.gif
This picture is an example which shows how the average tax percentage one has to pay increases as income increases