Are Sales Taxes More Regressive Than Income Taxes?

Income Taxes vs. Sales Taxes

Q:: I'm a Canadian who has been following the Canadian elections. I heard one of the parties claim that a reduction in sales taxes help the wealthy not the middle class or poor. I thought sales taxes were regressive and were mainly paid by low income people. Can you help me out?

A: Great question!

With any tax proposal, the devil is always in the details, so it's hard to analyze the exact impact a policy will have when all that exists is a promise that could fit on a bumper sticker. But we'll do our best with what we have.

First we should determine exactly what we mean by regressive taxation. The economics glossary defines a regressive tax as:

  1. A tax on income in which the proportion of tax paid relative to income decreases as income increases.

There's a couple things to note with this definition:

  1. Even under a regressive tax, higher income earners pay more than lower income earners. Some economists prefer to use the term regressive rate taxes to avoid confusion.
  2. When looking at taxes, 'progressive' or 'regressive' refers to levels of income, not wealth. Thus to say a progressive tax is one where 'the rich pay proportionately more' is a bit of a misnomer, since we usually think of someone as 'rich' who has a lot of wealth. That's not necessarily the same thing as having a high income; one can be rich without earning a dime in income.

Now we've seen the definition of regressivity, we can see why sales taxes are more regressive than income taxes. There's typically three main reasons:

  1. Wealthier people spend a small portion of their income on goods and services than poorer people. Wealth is not the same thing as income, but the two are closely related.
  2. Income taxes typically have a minimum income level at which you do not have to pay taxes. In Canada, this exemption is for people who make around $8,000 or less. Everyone, however, is forced to pay sales taxes, no matter their income.
  3. Most countries do not have a flat tax income rate. Instead the income tax rates are graduated - the higher your income, the higher the tax rate on that income. Sales taxes, however, stay the same no matter your income level.

Policy makers and economists realize that the, on average, citizens are not in favour of regressive rate taxation. Thus they've taken steps to make their sales taxes less regressive. In Canada the GST is exempt on items like food, which poorer people pay a disproprtionately larger portion of their income on. As well, the government issues GST rebate cheques to lower income households. To their credit, the FairTax lobby proposes giving every citizen a 'prebate' cheque in order to make their proposed sales tax less regressive.

The overall effect is that sales taxes such as the GST is more regressive than other taxes, such as income taxes. Thus a cut in the GST would help low- and medium-income earners more than a similar sized income tax cut. While I am not in favour of a cut in the GST, it would make the Canadian tax system more progressive.

Do you have a question about taxes or tax proposals? If so, please send it to me by using the feedback form.