In public finance, horizontal equity conforms to the concept that people with a similar ability to pay taxes should pay the same or similar amounts. It is related to tax neutrality or the idea that the tax system should not discriminate between similar things or people, or unduly distort behavior. Vertical equity usually refers to the idea that people with a greater ability to pay taxes should pay more.
Horizontal Equity, Vertical Equity, and Taxes
Income taxes are a laddered progressive tax where income tax rates are set in income bands or ranges. Each tax rate corresponds to a particular income range; income above a tax range is subject to a higher tax rate that corresponds to a higher income range and income below a specific range is subject to a lower tax rate, similarly identified with a lower income range. Within any given income range, the tax rate is the same.
The income range conforms with the idea that the individuals included within it are similar with respect to their ability to pay. The range can be identified as conforming to the concept of horizontal equity. Vertical equity follows from the laddering of income tax to progressively higher rates. The laddering of income taxes conforms to the underlying definition of vertical equity, as those who have a greater ability to pay tax, pay a higher proportion of their income.
Proportional taxes, conform to horizontal equity. By definition proportional taxes are levied in proportion to income. However, income taxes are only proportional within specific income ranges. At the highest income tax rate, income taxes can become regressive, since high earners are only subject to a constant albeit highest rate on their income. For example, income from $500,000 and above will be subject to the same rate, making the overall tax burden as a proportion of income higher for the individuals on the starting point of the range .
Income tax
Income tax is a progressive tax that assumes a regressive nature at the highest tax rate.
Tax efficiency and tax equity
The purpose of a progressive tax system is to increase the tax burden to those most able to pay. However, some policy makers believe that progressive taxation is an overall inefficiency within the tax structure. These individuals and groups support a flat tax or proportional tax instead. Their argument for a tax modification is related to the view that increasing the tax rate in conjunction with income creates a disincentive to individuals to earn more and is, as a result, punitive to those that achieve income related success. The net result from this reasoning is that progressive taxation results in lower GDP than would have resulted in a proportional tax regime, also referred to as a loss of economic efficiency.