Most, though not all, people view a progressive tax system as fairer than a regressive system. The reason is the ability-to-pay principle: a high-income family that pays 35% of its income in taxes is still left with a lot more money than a low-income family that pays only 15% in taxes. But attempts to make taxes strongly progressive run up against the trade-off between equity and efficiency.

To see why, consider a hypothetical example, illustrated in Table 7-3. We assume that there are two kinds of people in the nation of Taxmania: half of the population earns $40,000 a year and half earns $80,000, so the average income is $60,000 a year. We also assume that the Taxmanian government needs to collect one-fourth of that income—$15,000 a year per person—in taxes.

One way to raise this revenue would be through a proportional tax that takes one-fourth of everyone’s income. The results of this proportional tax are shown in the second column of Table 7-3: after taxes, lower-income Taxmanians would be left with an income of $30,000 a year and higher-income Taxmanians, $60,000.

Even this system might have some negative effects on incentives. Suppose, for example, that finishing college improves a Taxmanian’s chance of getting a higher-paying job. Some people who would invest time and effort in going to college in hopes of raising their income from $40,000 to $80,000, a $40,000 gain, might not bother if the potential gain is only $30,000, the after-tax difference in pay between a lower-paying and higher-paying job.

But a strongly progressive tax system could create a much bigger incentive problem. Suppose that the Taxmanian government decided to exempt the poorer half of the population from all taxes but still wanted to raise the same amount of revenue. To do this, it would have to collect $30,000 from each individual earning $80,000 a year. As the third column of Table 7-3 shows, people earning $80,000 would then be left with income after taxes of $50,000—only $10,000 more than the after-tax income of people earning half as much. This would greatly reduce the incentive for people to invest time and effort to raise their earnings.

The point here is that any income tax system will tax away part of the gain an individual gets by moving up the income scale, reducing the incentive to earn more. But a progressive tax takes away a larger share of the gain than a proportional tax, creating a more adverse effect on incentives. In comparing the incentive effects of tax systems, economists often focus on the marginal tax rate: the percentage of an increase in income that is taxed away. In this example, the marginal tax rate on income above $40,000 is 25% with proportional taxation but 75% with progressive taxation.

Our hypothetical example is much more extreme than the reality of progressive taxation in the modern United States—although, as the upcoming Economics in Action explains, in previous years the marginal tax rates paid by high earners were very high indeed. However, these have moderated over time as concerns arose about the severe incentive effects of extremely progressive taxes. In short, the ability-to-pay principle pushes governments toward a highly progressive tax system, but efficiency considerations push them the other way.