Tax equity considers a taxpayer’s ability to pay a tax and whether a tax payer’s effective tax rate (ETR) increases or declines with income. Taxes are typically considered regressive, progressive or proportionate.
An effective tax rate (ETR), used to classify a tax in terms of equity, is calculated by dividing the total amount of a tax paid by the tax payer’s total income. For example, a taxpayer who pays a yearly total of $3,000 in sales taxes and has an annual income of $40,000 has an effective tax rate of 7.5 percent (3,000 ÷ 40,000).
Effective Tax Rates and Tax Classifications
Effective tax rates are used to classify taxes in terms of equity. There are three general tax classifications:
- Regressive Taxes – With a regressive tax, the ETR declines as an individual’s income (ability to pay) increases. These taxes disproportionately impact those is less ability to pay.
- progressive Taxes– In contrast to a regressive tax, the ETR of a progressive tax increases as a taxpayer’s income or ability to pay grows. Progressive taxes place more of the tax burden on those with higher incomes and a greater ability to pay.
- Proportionate Taxes – A proportionate tax has an identical ETR for all tax payers regardless of income level and thus impacts all income classes the same.
Now, let’s consider some examples of these three types of taxes and provide a local government context.
A classic example of a progressive tax is the federal Income tax. The federal income tax is bracketed with higher rates applying as a taxpayer’s income, or ability to pay, increases. These brackets increase the effective tax rate for tax payers with higher incomes.
Local government context: there is debate on overall equity of the property tax, a major revenue source for most PA local governments.
Those claiming the property tax is more progressive assert the correlation between owning property/property values and income. Generally speaking, property ownership and property values are a proxy for an individual’s ability to pay a tax. Some say that property taxes are more like consumption taxes since property taxes are shifted forward to renters and therefore are not progressive, and disproportionately impacts individuals on fixed incomes. There’s no real consensus, but it likely that property taxes are less progressive than most incomes taxes and more progressive than traditional consumption taxes such as sales taxes.
Sales taxes are considered regressive because they result in a higher effective tax rate for those with less ability to pay. To illustrate this, we’ll use the following hypothetical scenarios involving two taxpayers: Taxpayer A and Taxpayer B.
- Taxpayer A is single and earns $35,000 a year. He spends $15,000 each year on goods subject to a 6% sales tax and therefore pays $900 each year in sales tax. Taxpayer A’s effective tax rate is 2.6% ($900 ÷ $35,000).
- Taxpayer B is single and earns $100,000 a year. He has more disposable income and spends $30,000— twice as much as Taxpayer A—on goods subject to a 6% sales tax. Taxpayer B pays $1,800 a year in sales tax and yet has just a 1.8% effective tax rate ($1,800 ÷ $100,000).
Or in other words, Taxpayer B’s effective tax rate is 30% lower than taxpayer A’s despite a greater ability to pay based on his higher income.
Local Government Context: the local service tax allows municipalities to collect a total of $52 a year to those employed in their community, deducted during payroll. The LST could be considered regressive in that the tax does not change based on income (except for an exemption for those making less than $12,000 annually) and therefore has a disproportionate impact on lower income individuals.
A proportionate tax, in terms of equity, is a tax in which the ETR does not change based on income or ability to pay. So, it is not considered regressive or progressive.
A good example of a proportionate tax is the local earned income tax (EIT). This tax uses a uniform rate on all earned income, so in theory employees that earned higher or lower annual wages should have the same effective tax rate with the EIT. This assumes that both taxpayers’ total yearly income is taxable under the EIT.
Horizontal equity, another tax equity consideration, refers to the principle that individuals with similar incomes should pay a similar amount in taxes.
Horizontal equity becomes a factor when taxpayers earn income or receive income from different sources. For instance, a taxpayer that makes $100,000 from investments (capital gains) will pay less than a wage earner making $100,000 subject to the federal income tax as capital gains are taxed at a lower rate.
Local government context: In PA, retirement income is exempt from the local earned income tax. Therefore, a resident receiving $50,000 a year on a pension will not pay any earned income tax compared to the resident who earned $50,000 in wages that are taxed at the rate set by the municipality.
Overall tax equity should be a factor when assembling your tax plan for your community. However, local governments are confined by state laws to certain taxes and tax structures and therefore do not have latitude to impose new taxes not enabled by the state or to modify existing taxes to make them more progressive unless the authority to do so in provided via statute. For example, a municipality is not able to increase the earned income tax above its cap of 1.5% and cannot add additional rates that apply to those who earn more or less income.