Three Types of Tax Systems

The three most important types of tax systems are proportional, regressive, and progressive tax systems. The main difference between them is how the tax rate changes in relation to the income of the taxpayer.

1. Proportional Tax System
Proportional taxes require all taxpayers to pay the same fraction of their income, regardless of how much money they earn. That means the tax rate doesn’t change as the income increases or decreases. Therefore, this system is also commonly referred to as a flat tax.
To illustrate this, meet John, Jake, and Jane. John works as a construction worker and earns USD 50,000 a year. Meanwhile, Jake works as a private investigator and earns USD 100,000 a year. And finally, the highest earner of the group is Jane, who works as an Astronaut and earns USD 200,000 a year.
In a proportional tax system, our three friends are all taxes at the same rate. Say, 20% of their annual income. In that case, John has to pay USD 10,000 in taxes, whereas Jake’s tax bill adds up to USD 20,000 and Jane has to pay USD 40,000. As you can see, in this system the burden of the tax increases proportionally to the income of our three taxpayers, because the tax rate is fixed.

2. Regressive Tax System
Regressive taxes require high-income earners to pay a smaller fraction of their income than those with a lower income. That means as the income grows, the tax rate decreases. One of the most common examples of a regressive tax is a sales tax, which is a tax placed on the sale of a good or service. Because the amount of that tax is the same for all buyers, the fraction of income devoted to paying it decreases as the income of the taxpayer increases.
To illustrate this, let’s revisit our three friends. Now assume they all bought a new car worth USD 50,000 with a sales tax of exactly 10%. That means they all have to pay USD 5,000 in additional taxes. Now, if we calculate the tax rate in relation to their income, we can see that John has to spend 10% of his annual income to pay the sales tax. Meanwhile, Jake has to devote 5% of his income and Jane only spends 2.5% of her annual income to pay the exact same tax. So relatively speaking, in this system, the burden of the tax decreases as the income of our three taxpayers grows.

3. Progressive Tax System
Progressive taxes require high-income taxpayers to pay a larger fraction of their income than taxpayers with a lower income. That means as the income grows, so does the tax rate. The idea behind this is that wealthy people spend relatively less on the basic necessities in life, so they can afford to pay more taxes and still maintain their standard of living.
To see how that works, consider a progressive tax system with three tax brackets: (1) people who earn up to USD 75,000 pay a 5% income tax, (2) people who earn between 75,000 and USD 150,000 pay 10%, and (3) people who make more than USD 150,000 pay a 20% income tax. That places John, Jake, and Jane in three different brackets. John only has to pay a 5% income tax, which adds up to USD 2,500 in his case. Meanwhile, Jake has to pay 10% of his income in taxes, which is equal to USD 10,000. And finally, Jane’s income is taxed at 20%, which means she has to pay USD 40,000.
Note that despite the higher tax rate, Jane still has more money after paying the tax than the other two, and Jake still has more than John. Therefore, the higher tax burden doesn’t affect them as much because they can afford to pay more and still have enough money in the bank.

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