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Taxes can be distinguished by the effect they have on the distribution of income and wealth. A proportional tax is a kind that imposes the same relative liability on all the taxpayers—i.e., when tax liability and income increase in equal proportion. A progressive tax is recognised by a larger than proportional growth in the tax liability relative to the growth in income, and a regressive tax is characterized by a less than proportional rise in the relative onus. So, progressive taxes are seen as fighting inequity in income distribution, whereas regressive taxes can cause an increase in these inequalities.

The taxes that are generally believed to be progressive include individual income taxes and estate taxes. Income taxes that are initially progressive, however, can become less so in the upper-income group—especially if a taxpayer is allowed to lessen his tax base by claiming deductions or by removing certain income elements from his taxable income. Proportional tax rates if applied to lower-income categories will also be more progressive if such personal exemptions are claimed.

Income measured over the period of a year does not necessarily provide the best measure of taxpaying ability. For example, transitory growth in income could be saved, and in temporary declines in income a taxpayer might select to pay for consumption by reducing savings. Thus, if taxation is made comparable along with “permanent income,” it should be less regressive (or more progressive) than if compared with annual income.

Sales taxes and excises (except luxuries) are mostly regressive, because the spread of individual income consumed or spent on specific goods declines as the amount of personal income increases. Poll taxes (aka head taxes), nominated as a standard amount per capita, patently are regressive.

It is not easy to term corporate income taxes and taxes on business as progressive, regressive, or proportionate, because of uncertainty about the ability of businesses to shift their tax expenses (see below Shifting and incidence). This difficulty of deciding who bears the tax burden is dependant fundamentally on whether a national or a subnational (that is, provincial or state) tax is being debated.

In considering the economic purposes of taxation, it is important to distinguish between several ideas of tax rates. The statutory rates are nominated in the law; usually these are marginal rates, but occasionally they are median rates. Marginal income tax rates indicate the fraction of incremental income that is taken by taxation when income grows by one dollar. Therefore, if tax liability grows by 45 cents when income increases by one dollar, the marginal tax rate is 45 percent. Income tax laws generally contain graduated marginal rates—i.e., rates that increase as income increases. Careful analysis of marginal tax rates should take into account provisions other than the formal statutory rate structure. If, for example, a particular tax credit (reduction in tax) declines by 20 cents for each one-dollar rise in income, the marginal rate is 20 percentage points greater than indicated within the statutory rates. Since marginal rates indicate how after-tax income is changed in response to changes in before-tax income, they are the appropriate ones for considering incentive effects of taxation. It is even more complicated to nominate the marginal effective tax rate applied to income from business and capital, because it may rely on factors including the structure of depreciation allowances, the deductibility of interest, and the provisions for inflation adjustment. A basic economic theorem shows that the marginal effective tax rate in income from capital is zero under a consumption-based tax.

Average income tax rates determine the percentage of total income that is required in taxation. The pattern of average rates is the one that is necessary for considering the distributional equity of taxation. Under a progressive income tax the average income tax rate increases with income. Average income tax rates generally rise with income, both because personal allowances are provided for the taxpayer and dependents and also because marginal tax rates are graduated; on the flip side, preferential treatment of income received for the most part by high-income households could dwarf these effects, producing regressivity, as indicated by average tax rates that lower as income grows.

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