Vertical Equity

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Last Updated:December 26, 2023

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What Is Vertical Equity?

The income tax collection strategy known as "vertical equity" involves increasing the amount of taxes paid in proportion to the income produced. Vertical equity is predicated on the idea that individuals who can afford to pay more taxes ought to make larger contributions than those who cannot.

With the vertical equity method of income tax collection, the amount of tax paid rises as earned income does. In a vertical equity system, an individual's income tax obligation grows in proportion to their income.

It is based on the idea that those who can afford to pay more taxes should make greater contributions than those who cannot.

It is founded on the idea that people who earn more money and have more assets should pay a higher income tax than average. The horizontal equity system is the antithesis of the vertical equity system.

It is the most extensively used taxation approach globally since it considers charging taxes according to one's ability to pay.

When it comes to income-based taxes, implementing the idea of vertical equity is considerably simpler than when it comes to asset-based taxes.

Because income is movable, unlike assets, which are not, some assets can be at least partially monetized. You might be able to rent out a room in your house, for instance.

In the actual world, a person's home is typically their single largest asset. Moreover, homes frequently increase in value. Therefore a vertical equity system would entail a greater degree of taxation.

Understanding Vertical Equity

All residents of a state must bear the same share of the tax burden. According to the "ability to pay" principle, an individual's overall tax obligation should be inversely correlated to their total wealth or capacity to pay the specified tax burden.

It is used to ensure that those who earn more pay more. However, it is compatible with horizontal equity because it is still conceivable for people in similar circumstances to receive the same treatment.

A tax system's equity determines whether taxes equally burden the populace. According to the ability to pay principle, the amount of tax a person must pay should be determined by how much of a burden it will place on them, given their wealth.

Two concepts of fairness and equity—vertical and horizontal equity—are derived from the ability to pay principle. The idea behind it is that higher earners should be subject to higher tax rates.

In a proportional taxation system, income directly affects how much is paid in taxes. However, since the effective average tax rate does not vary with income, everyone pays the same percentage of their income in taxes.

Types of Vertical Equity

One of the three types that vertical equity can be divided into is proportional, regressive, or progressive taxation.

These designations concentrate on the correlation between tax rates and income because all taxes, whether imposed on income or goods, buildings, or land parcels, are ultimately paid out of an individual's income.

Progressive Taxation

The average tax rate rises under progressive taxation as an individual's income rises. An individual's income is taxed according to multiple tax brackets, each of which has a different tax rate; the higher an individual's annual revenue, the higher the tax bracket.

The top income earners in a nation pay the greatest effective tax rates, which indicates that a millionaire pays a higher percentage of their income in taxes than a middle-class school teacher.

Example

If an individual earns $80,000 and is subject to the following tax slabs or brackets,

0 – $ 50,000 = 10%
$ 50,000 – $ 100,000 = 20%
above $ 100,000 = 30%

As a result, the individual's tax would fall under slabs 1 and 2, meaning that income of $ 50,000 would be taxed at 10%, or $ 5,000.

The remaining $ 30,000 ($80,000 - $ 50,000) will be taxed at 20%, or $ 6,000. Therefore, the total tax will be $ 11,000.00.

Proportional Taxation

The proportional tax technique charges income at a single rate regardless of the taxpayer's income class. As a result, an individual's absolute tax liability rises proportionately as their wealth does, and the opposite is also true.

Example

For all income levels, the tax rate is a flat 10%, so someone making $70,000 will pay $7,000 in taxes, and someone making $250,000 will pay $25,000 in taxes.

Because the person with the higher income is paying more tax to the government, we can see that the concept of vertical equity is being upheld in this situation.

Regressive Taxation

A tax is deemed regressive if its average rate decreases as income rises. As income rises, a tax like this takes a decreasing percentage. As income increases, a regressive tax may or may not take a larger absolute quantity of remuneration.

Example

In this instance, you pay 15% if your income is under $10,000; 10% if it is between $10,000 and $20,000; 5% if it is between $20,000 and $30,000; and so on.

Summary

Let us summarize the concept of vertical equity in short through the points below:

With a vertical equity system, taxes are paid higher as income rises.
The foundation of vertical equity is the ability-to-pay concept, achieved by proportionate or progressive taxation.
It is frequently easier to attain than horizontal equity, which tax breaks and loopholes can compromise.
In an economy with numerous tax benefits like tax credits, exemptions, deductions, etc., it is simpler to execute than horizontal equity.

The "benefit principle of taxation," or the notion that people who benefit more from government services should pay more taxes, is another argument in favor of vertical equity.

Wealthier people gain more from government-supported national military, police, and fire protection as they have more assets to lose in a war or disaster.

Tax equity rules would not be necessary if everyone could agree on just the principles and the pertinent empirical data. However, horizontal and vertical equity significantly impact tax policy when there is moral and empirical disagreement.

This explanation of tax equity demonstrates the value of non-ideal political theory. Moreover, it offers a strong argument for the ethical importance of pre-tax income without relying on "natural property rights'' or pre-institutional moral desert.