Vertical Equity

Updated on January 4, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Vertical Equity?

Vertical equity refers to the tax system whereby  those who earn more should pay more tax than those who earn less. This means people falling in a higher income group should be charged with a higher tax rate than those in the lower-income group. This arrangement aims to establish a fairer taxation system in any economy.

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This process of taxation lets the population be treated equally, given their tax burden is decided with respect to their level of income. Since this method considers charging taxes based on the ability to pay, it is the most widely accepted taxation method by various countries worldwide.

Key Takeaways

  • Vertical equity refers to the principle that individuals with higher incomes should be subject to a higher tax rate than those with lower incomes. 
  • This approach ensures that individuals in higher income brackets contribute a larger portion of their income in taxes overall. 
  • Progressive taxation is a system that follows the principle of vertical equity. Under progressive taxation, the average tax rate increases as an individual’s income rises. 
  • The implementation of horizontal equity becomes challenging in an economy with numerous tax incentives, such as rebates, tax credits, deductions, exemptions, and so on. 

Vertical Equity Explained

Vertical equity is a system where more tax is paid by an individual who earns more. Likewise, those who earn less contribute less as taxes. In short, it is the arrangement that takes into account the ability of one to pay taxes and accordingly puts the tax burden on them.

It is easy to implement for an economy as compared to horizontal equity where there are multiple tax benefits like tax credits, exemptions, deductions, etc., which affect the income range of people despite them having the same income level.

Vertical equity arrangement is how the United States taxes its citizens. The country ensures that those who can afford to pay more receive a higher tax bill than the ones who earn less or do not have the capacity to pay taxes. This way, it ensures a progressive society with proportionate taxation arrangements.

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The vertical equity system taxes citizens on their net taxable income and not their gross income. Gross income is the income considered before any deductions are made, while net income is the amount that is recorded after the applicable deductions are done.

However, in some instances, these deductions lower the tax liabilities of people despite their hefty earnings. This is where vertical equity seems to have a loophole as the tax deductions applicable to citizens differ.

It may happen that a person earning more but having access to multiple rax deductions would pay less tax, while another person earning less than the former with access to only a few tax deductions ends up paying more tax than them.

Types

Tax is charged in two different ways under the vertical equity method. This is what brings one to different types of vertical equity in taxation. Let us have a look at them:

  • Progressive Taxation
  • Proportional Taxation
Vertical Equity Types

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#1 – Progressive Taxation

Under progressive taxationProgressive TaxationProgressive tax refers to the increase in the average rate of tax with the increase in the amount of taxable income so that the liability of paying heavy taxes passes to those who earn a higher income and those with lower income can have a relaxation from the heavy income tax obligations.read more, 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.

Let us cite an example here. 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 taxProportional TaxA proportional tax is a single-rated tax in which all incomes are taxed at a flat fixed rate regardless of the type of person or type of income, removing the concept of greater and lower earnings.read more method, the income is charged at a single rate irrespective of the income class of the tax payee.

For example, if 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.

Examples

Let us consider the following examples to understand the meaning of vertical equity and also look at how it works:

Example 1

Country A has a 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.

Vertical-Equity

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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

Example 2

In May 2023, New Zealand Revenue Minister David Parker introduced The Taxation Principles Reporting Bill. In the bill, he has advocated for having a vertical equity arrangement, which would ensure equal treatment of citizens belonging to unequal income groups.

The introduction of the bill came following his 2022 announcement regarding his plans to bring into place a fairer tax system in the country.

Vertical Equity vs Horizontal Equity

Both horizontal and vertical equity are considered important terms when it comes to taxation. However, they signify two different perspectives. Let us have a look at the differences between the terms below:

Frequently Asked Questions (FAQs)

1. What are the advantages of a vertical equity system?

The advantages of a vertical equity system include promoting fairness and social justice by ensuring that individuals with higher incomes contribute a larger portion of their income in taxes. This helps redistribute wealth and reduce income inequality, leading to a more equitable society.

2. What are the risks associated with a vertical equity system?

Risks associated with a vertical equity system include the potential impact on incentives for work and productivity. High tax rates on higher incomes may discourage individuals from working harder or seeking higher-paying jobs, potentially hampering economic growth. Additionally, implementing and administering complex tax systems to achieve vertical equity can be challenging and costly.

3. Is vertical equity important for economic growth?

Vertical equity is important for economic growth to a certain extent. While it promotes fairness and social cohesion, excessively high tax rates on higher incomes can disincentivize investment, entrepreneurship, and innovation. Striking the right balance between equity and incentivizing economic activity is crucial for sustainable economic growth.

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