Vertical Equity

What is Vertical Equity?

Vertical equity is a method of collecting income tax in which taxes paid increase with the amount of income earned. The guiding principle of vertical equity is that those with the ability to pay more taxes should contribute more than those who are not.

This can be contrasted with horizontal equitythat people with similar incomes and assets should pay the same amount of tax.

Understanding vertical equity

The fairness of a tax system indicates whether the tax burden is distributed fairly among the population. The ability to pay The principle states that the amount of tax an individual pays should depend on the level of burden the tax will create relative to the individual’s wealth. The principle of ability to pay gives rise to two notions of justice and equity: vertical and horizontal equity.

Vertical equity leads to the principle that people with higher incomes should pay more taxes, through proportional or progressive tax rates. In proportional taxation, the amount of taxes paid increases directly with income. Everyone pays the same proportion of their income in tax since the average effective tax rate does not change with income.

Key points to remember

  • Vertical equity is a method of income taxation whereby more taxes are paid as income increases.
  • Vertical equity is based on the principle of ability to pay through progressive tax rates or proportional taxation.
  • Vertical equity is often more achievable than horizontal equity, which can be compromised by loopholes and deductions.

Example of vertical equity

For example of vertical equity, consider a taxpayer who earns $100,000 per year and another who earns $50,000 per year. If the tax rate is fixed and proportional at 15%, the highest income earner will pay $15,000 in tax for the given tax year, while the taxpayer with the lowest income will have a tax liability of $7,500. With the same rate applied to all income amounts, people with more resources or higher income levels will always pay more dollar tax than people with lower incomes.

Progressive taxation

Progressive taxation includes tax brackets, where people pay taxes according to the tax bracket their income places them in. Each tax bracket will have a different tax rate, with the higher income brackets paying the higher percentages. In this tax system, effective average tax rates increase with income, so that the wealthy pay a higher share of their income in taxes than people with reported incomes in the lowest income bracket. For example, in the United States, a single taxpayer earning $100,000 has a top marginal tax rate of 24%, as of 2019. Their tax liability would be $18,174.50 for an effective tax rate of 18.17%. The top marginal tax rate for a single taxpayer with an annual income of $50,000 is 22%. In this case, this taxpayer would pay $6,864 for an effective tax rate of 13.73%.

The other criterion used to measure equity in a tax system is horizontal equity, which states that people with similar ability to pay should contribute the same amount of taxes to the economy. The basis of this notion is that people in the same income group are equal in their ability to contribute to society and therefore should be treated equally when imposing the same level of income tax. For example, if two taxpayers earn $50,000, they should both be taxed at the same rate since they both have the same wealth or are in the same income bracket. However, horizontal equity is difficult to achieve in a tax system where loopholes, deductions and incentives, because granting tax relief means that similar individuals do not actually pay the same rate.

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