Vertical Equity

Vertical Equity Definition

Vertical Equity means that those who earn more should pay more, which means people falling in a higher income group should be charged with a higher tax rate than those in the lower income group. Since this method considers charging taxes based on the ability to pay it is the most widely accepted taxation method by various countries around the world.

Types of Vertical Equity

Tax is charged in two different ways under vertical equity method viz.

• Progressive Taxation
• Proportional Taxation

#1 – Progressive Taxation

Under progressive taxation, the average tax rate increases as the income of a person increases. The income of an individual is charged using various tax brackets, each bracket will have a different tax rate i.e. higher the annual income of an individual higher is the tax bracket.

Example

Suppose the income of an individual is $ 100,000 and the tax slabs/brackets are as follows,

• 0 – $ 50,000 = 10%
• $ 50,001 – $ 100,000 = 20%
• above $ 100,000 = 30%

Therefore as per the above example, the tax of the individual would be under-slab 1 and 2 i.e. income up to $ 50,000 will be taxed at 10% which will come to $ 5,000 and the remaining $ 50,000 ($ 100,000 – $ 50,000) will be taxed at 20% i.e. $ 10,000. So the total tax will be $ 15,000.

#2 – Proportional Taxation

Under the proportional tax method, the income is charged at a single rate irrespective of the income class of the tax payee.

Example

The tax rate is flat 10% for all income groups i.e. a person earning $70,000 annually will pay a tax of $7,000 and a person earning $250,000 annually will have to pay $25,000. Therefore we can see here that the principle of vertical equity is being followed as the individual with the higher income is paying more tax to the government.

Example of Vertical Equity

Solution

Country A has the progressive tax structure in place and the slabs are as below,

• Up to $ 10,000 = 5%
• $ 10,001 – $ 20,000 = 10%
• above $ 20,000 = 30%

The income of John for the financial year is $ 60,000 we are required to calculate the tax on the same.

Solution

Here the income of John is $ 60,000, which makes him part of all 3 slabs. It is important to understand the fact that income of $ 60,000 doesn’t mean that entire income will be charged at 30%, it means income above $ 20,000 will be charged at 30% rate, i.e. in our example, the income of $ 40,000 will be charged at 30%, $ 10,000 will be charged at the rate of 10 % and balance $ 10,000 at 5%.

Therefore the tax for Mr. John will be = 40,000 * 30% + 10,000 * 10% + 10,000 * 5%
= $ 13,500

Vertical Equity vs Horizontal Equity

• The concept of Horizontal Equity states that individuals with the same income or assets class should be charged the same amount of taxes i.e. “equal treatment for equals”. This means if two individuals earn an income of $ 30,000 per annum, both should pay tax amounting to $ 3,000 only. Whereas the concept of Vertical Equity states that higher the income of the individual higher would be the average tax rate. It works on the principle that those who earn more should pay more.
• The horizontal Equity method is difficult to apply in the economy where there are various tax benefits like rebates, tax credits, deductions, exemptions, etc. due to such benefits there will be inequality of tax amount despite the income for people being the same i.e. if one person gets a deduction for payment of housing loan then he will get a lower amount of tax as compared to the one who hasn’t paid any housing loan. This will make the horizontal equity method ineffective.

Conclusion

• Vertical equity is a system where more tax is paid by an individual as the income increases.
• Tax is charged using two methods viz. Progressive Taxation and Proportional taxation
• It is easy to implement as compared to Horizontal equity for an economy where there are multiple tax benefits like tax credits, exemptions, deductions, etc.

Recommended Articles

This has been a guide to Vertical Equity and its Definition. Here we discuss types of vertical equity along with its examples and differences from horizontal equity. You can learn more about financing from the following articles –

• Corporate Tax
• Payroll Tax
• Flat Tax
• Tax Accounting