Introduction to Income Distribution

Tax Deductions

• It important to note that the previous example represents a very simplified tax structure.
• In reality most countries tax structures are infinitely more complicated.
• The biggest complication comes in the form of tax deductions and the calculation of taxable income.
• Tax deductions allow people to reduce their “taxable income” as result of spending of items that relate directly to their work.

Example of Tax Deductions

• For example, if a worker must travel a long

distance to work and this costs $1000 a month,

the government might allow the person to

deduct this spending from her taxable income,

thus reducing the amount of tax that she pays.

• The government might do this because it feels that this will encourage people to find work and lower unemployment.
• What is considered to be a tax deduction is different from country to country

Regressive Taxes

• A tax is known as a regressive tax if the proportion of income paid in tax (the average rate of tax) falls as income rises.
• Indirect taxes are regressive taxes.
• GST or Sales taxe are regressive taxes.

Regressive Tax - Example

• Assume there is a $1.00 tax on every litre of petrol.
• The average commuter spends about $50 per month in petrol taxes.
• For a person earning $500 per month, the tax will take 10% of their income.
• For a person earning $2500 per month, the tax will represent 2% of their income.
• The tax is regressive because a higher proportion of income is paid at lower levels of income.

Regressive Taxes exacerbate income inequality

• Regressive Taxes may be a good source of government revenue and they might discourage the consumption of demerit goods, BUT THEY CAN WORSEN INCOME INEQUALITY.

Proportional Taxes

• A tax is proportional, if the proportion of income paid in tax is constant for all income levels.
• Many countries are now promoting the idea of proportional direct taxes or flat taxes, whereby the same percentage of tax is paid at all levels of income.