In Microeconomics, we studied how governments can impose indirect taxes on goods and services in the product market, either through specific or ad valorem (percentage tax). In these situations, the consumer had the choice whether or not to pay the tax through the choice to consume the good or not. If they did not consume the good, they did not pay the indirect tax. 

Direct taxation on the other hand is taxation placed directly onto household income (income tax) or firms profits (Corporation Tax). In this respect, every household who receives an income and every firm who makes a profit pays taxation to the government. There are three different forms of direct taxation: 

• Progressive

• Proportional

• Regressive

Governments can use direct taxation as a way to redistribute the income through using the revenue received through taxation to fund things such as merit goods, infrastructure or payments made to different groups called Transfer Payments. (For example, if the government paid an individual who was unemployed some form of payment to protect them from experiencing poverty).

Average Tax Rate - The average tax rate is the total amount of tax paid as a proportion of the total income. This tells us how much on average the income

Marginal Tax Rate - Marginal tax rate refers to the percentage of tax paid on an additional dollar of income earned. It represents the tax rate applied to the last portion of an individual's income, typically in progressive tax systems. As income rises, higher marginal tax rates are applied to higher income brackets.

Proportional Tax System - Average tax rate is the same for everyone regardless of income. Often called a “flat tax” as the rate remains the same for everyone.  Marginal Tax Rate = Average Tax Rate

Progressive Tax System - Average tax rate increases as incomes rise. Those on higher incomes will have a higher average tax rate than those on lower incomes.  Marginal Tax Rate > Average Tax Rate

Regressive Tax System - Average tax rate decreases as incomes rise. Those on lower incomes will have a higher average tax rate than those on higher incomes. Marginal Tax Rate < Average Tax Rate

We will need to be able to calculate: 

a) How much tax someone pays in total 

b) The average tax rate they pay 

c) The Marginal Tax rate they pay. 

In order to calculate the tax paid, most countries use various tax brackets. In the below example, we can see that the tax paid increases as income rise. However, it is important to note, that the brackets represent an amount of an individuals income and that everyone pays the same tax rate on the bracket of income. Let's take a look at some examples below: 

Note: A common mistake made is that individuals pay the tax rate that their total income falls into. For example, the error would be to say that Person A pays 18% tax and Person C pays 25%. This is not the case for progressive tax systems as we will see below. 

As we can see, with a proportional tax system, those on higher incomes will benefit the most as they would pay less tax whereas those on the lower incomes (Persons A&B) would pay more than under a progressive tax system. This is why progressive tax systems are considered more equitable and help promote a more equitable distribution of income.

We can also see that the total tax paid by all individuals is less for proportional tax system ($27,900) compared to a progressive tax system ($30,274).