Regressive Tax
A regressive tax is a tax whose average rate falls as the base rises, so that it takes a larger share of income from lower-income households than from higher-income ones. The regressivity of a tax depends on its structure and on the distribution of the base among households, and it is assessed relative to income, since the burden of a tax is judged by the share of income it absorbs. Regressive taxes are common and are often criticised for their distributional effects.
The concept
A tax is regressive if the average tax rate declines as the base increases. A poll tax, levied as a fixed amount per person, is regressive with respect to income, because it takes a larger share from those with lower incomes. A sales tax on necessities is regressive if lower-income households spend a larger share of their income on the taxed goods, which is typically the case, since they save little and consume most of their income.
The assessment of regressivity requires attention to the correct measure of the base. A tax on consumption is regressive when measured against income, because lower-income households consume a larger share of their income, but it may be proportional or even progressive when measured against consumption or lifetime income, since consumption and lifetime income are more closely related than annual income and consumption. The choice of the measure therefore matters for the conclusion.
Examples
Examples of regressive taxes include sales taxes and value added taxes on necessities, excise duties on fuel and on basic goods, property taxes that fall on housing consumed by lower-income households, and payroll taxes that apply only up to a ceiling. Poll taxes and user fees, such as charges for public services, are also regressive if they are not related to ability to pay.
The incidence of a tax determines its regressivity. A tax that is legally levied on businesses may be largely passed on to consumers, and if those consumers are predominantly lower-income, the tax is regressive in effect. The analysis of regressivity therefore requires an assessment of the economic incidence, not only of the legal obligation, and it considers the effect of the tax on prices and on the distribution of income.
Concerns
Regressive taxes raise concerns about fairness and about the adequacy of the incomes of lower-income households. Because they take a larger share of income from those who can least afford it, they can increase inequality and can push households into poverty, particularly when the taxes apply to necessities. The concerns are heightened when the revenue is not used to provide benefits that offset the burden.
The concerns are not always decisive. Regressive taxes on harmful goods, such as alcohol and tobacco, may be justified by the objective of reducing consumption, and the burden may fall partly on those whose consumption imposes costs on others. Taxes on carbon and on pollution are regressive in their direct effect but may be justified by the environmental objective, and the revenue can be used to offset the burden on lower-income households, through transfers or through reductions in other taxes.
Mitigation
The regressive effects of taxes can be mitigated through several measures. Reducing or eliminating taxes on necessities, such as food and medicine, lowers the burden on lower-income households, though it also narrows the base and raises the rates needed to collect a given revenue. Providing targeted transfers or refundable credits that offset the burden can achieve the same objective more efficiently, because it directs support to those who need it.
The use of the revenue is also important. If the revenue from a regressive tax is used to fund progressive spending, such as education, health, or targeted transfers, the overall effect on the distribution may be progressive or neutral, even if the tax itself is regressive. The assessment of a tax should therefore consider the overall effect of the tax and the spending it finances, rather than the tax in isolation.
Measuring regressivity
Measuring the regressivity of a tax requires data on the distribution of the base and on the pattern of expenditure and income across households. Analysts compute the share of income paid in tax for each income group and examine how the share changes across the distribution. A tax is regressive if the share falls as income rises, and the degree of regressivity is measured by the change in the share across the distribution.
The measurement is sensitive to the choice of the base. Regressivity assessed against annual income can be more pronounced than when assessed against consumption or lifetime income, because annual income is more volatile and because consumption is smoother. The treatment of transfers and of the spending financed by the tax also matters, and the assessment of the overall effect requires considering the tax and the spending together.
Regressive taxes and corrections
The regressivity of a tax can be corrected through several mechanisms. Exempting or reducing the rate on necessities lowers the burden on lower-income households, at the cost of narrowing the base. Refundable credits or transfers that offset the tax can achieve the same objective more efficiently, by directing support to those who need it without distorting the structure of prices.
The design of the correction must consider the other objectives of the tax. If the tax is intended to discourage a harmful activity, exempting some households may weaken the incentive effect, and a direct transfer may be preferable. If the tax is intended mainly to raise revenue, the correction can be designed to preserve the revenue while addressing the distributional effect. The choice depends on the objectives and on the relative efficiency of the instruments.
Regressivity and public finance
The analysis of regressivity informs the overall assessment of a tax system. A system may include some regressive taxes and some progressive ones, and the overall effect depends on the combination. The assessment of whether a tax system is progressive requires considering all the taxes and transfers together, and it is not determined by the progressivity of any single instrument.
The analysis also informs the design of reforms. When considering a change in a tax, the effects on the distribution must be assessed alongside the effects on revenue and on efficiency, and reforms are often accompanied by measures to offset the distributional effects. The choice of instruments reflects judgments about the objectives of the system and about the trade-offs among them, and it is informed by analysis of incidence and of the distributional effects of alternative designs.
Lessons from experience
The experience of countries with different tax systems provides lessons about the effects of regressive taxes. Value added taxes, which are generally regressive against income, are used widely because of their efficiency and their revenue yield, and their regressivity is often addressed through reduced rates on necessities and through transfers. Taxes on fuel and on carbon, which are also regressive, are used for environmental objectives, with the revenue often used to offset the burden on lower-income households.
The experience shows that regressivity is not a decisive argument against a tax, but a consideration that must be addressed in the design. The appropriate response depends on the objectives of the tax, on the available instruments, and on the constraints of the fiscal system. The design of a regressive tax therefore involves a balance among the objectives of revenue, efficiency, and equity, and the outcome depends on the specific circumstances and on the choices made.