What is 'Vertical Equity'

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

BREAKING DOWN 'Vertical Equity'

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

Vertical equity drives the principle that people with higher incomes should pay more tax, through proportional or progressive tax rates. In proportional taxation, the amount of taxes paid increases directly with income. Everyone pays the same proportion of his or her income in tax since the effective average tax rate does not change with income. For example, consider a taxpayer that earns $100,000 per annum and another that earns $50,000 per annum. If the progressive tax rate is 15%, the higher income earner will pay $15,000 tax for the given tax year, while the taxpayer with the lower income will have a tax liability of $7,500. With the same rate applied across all income amounts, the individuals with more resources or higher income levels will always pay more tax in dollars than lower earners.

Progressive taxation includes tax brackets, in which people pay taxes based on the tax bracket that their income places them. Each tax bracket will have a different tax rate, with higher income brackets paying the highest percentages. Under this taxation system, effective average tax rates increase with income, so that the rich pay a higher share of their income in taxes than do the poor. For example, in the United States, an individual that earns $100,000 falls in the 24% tax bracket. His income tax assessed for the year will be $24,000. The 22% tax bracket applies to an individual whose annual income is $50,000. In this case, this taxpayer will be subject to $11,000 in taxes.

The other yardstick that is used to measure equity in a taxation system is the horizontal equity, which states that people with similar abilities to pay should contribute the same amount in taxes to the economy. The basis behind this notion is that people in the same income group are equal in their contribution capacity to society and, thus, should be treated the same by imposing the same level of income tax. For example, if two taxpayers earn $50,000, they should both be taxed the same rate since they both have the same wealth or fall within the same income bracket. However, horizontal equity is hard to achieve in a tax system with loopholes, deductions and incentives, because the provision of any tax break means that similar individuals effectively do not pay the same rate.

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