What is the need for progressive tax rates?

Question

I learnt that progressive tax rates are used in order to be fair (i.e. collect more from people earning more and lesser from people earning less) but, even if the same percentage of income is collected as tax from everybody, the person earning more will pay more (because 50% of 100 is clearly greater than 50% of 10). Then, what is the need for progressive tax rates?

Answer 1

From a personal finance perspective, the intuition behind progressive tax rates is the concept of diminishing marginal utility. For example, if you have a million dollars, what impact would finding $5 on the ground have on your life? On the flip side, if you have no money then $5 means you can eat today.

As another example, $10,000 can buy a jet ski - so why doesn't everyone making $10,000 a year have a jet ski? Of course, its because there are far more pressing demands at low income levels than entertainment - basic food and shelter comes first.

On the flip side, how painful is it to have to pay $5,000 in taxes, in terms of real measurable effect on someone's material lifestyle? If you only make $10,000 a year, this cuts into your ability to buy basic necessities. If you make $500,000 a year, paying $250,000 would still be unpleasant for most people, but it would not be the difference in having food to eat and a safe place to sleep.

The same basic intuition is important to other areas of personal finance, for instance savings vs investment. If you have no savings, it is critically important to start building such an emergency fund. However, once you get to a certain point (3-6 months of normal living expenses is the common advice), putting more into the emergency fund has diminishing usefulness - better to start moving extra money into others things instead, like paying off debt, long-term investing, etc.

Coming back to taxes, there is an old joke that taxation is like plucking feathers from a goose - the goal is to get the largest number of feathers with the smallest amount of hissing. Progressive tax rates is one way to do just that. You set small - or even negative - tax rates on people with small incomes, so you get little complaint, no complaint, or even praise for the system from those people. Then you have higher marginal rates as you earn more, but people who are paying these taxes have a lot more material comfort and financial security than most people so they don't start setting stuff on fire. More wealthy people pay even higher taxes, but in theory they already are living so much better than everyone else that a certain degree of decorum tends to prevent them from doing as much hissing as they would do ("aww, poor rich people can barely afford their fourth summer mansion, how sad, someone get the world's smallest violin"). In practice, of course, things don't always work like this - people with more money have more resources while being fewer in number, so they can pay teams of clever people to think up clever ways to rarely pay any portion of income at the higher tax rates, engage in rent-seeking to create special tax incentives that almost never apply to anyone unlike them, etc.

This is beyond personal finance, but the re-distributive aspect (especially with negative tax rates) is at least partially meant to try to balance the benefits of modern society out among the people. While some of this is an argument in favor of social justice, there is also an important argument that extreme inequality destabilizes society and tends to prompt big bad results like revolution, riots, assassinations, kidnappings, etc. So progressive tax rates are argued to be a way to try to put the brakes on the tendency of a small percentage of people to build massive golden mansions they don't get to enjoy for long because they end up being led to the guillotine.

At least, that's the political theory, but in terms of personal finance its most important to understand how progressive tax rates work, and thus how they should effect decision making on planning retirement, evaluating the value of education/certification (making less money over some number of years in exchange for making more money for a smaller number of years later - but much of that excess being taxed at a higher rate, for instance), etc.