Vertical equity is a method of taxation wherein the personal income tax liability of an individual increases as their income increases. It is based on the principle that individuals with higher incomes and more assets must pay a higher income tax than others. The opposite of the vertical equity system is the horizontal equity system.
According to the horizontal system, all citizens of a country are subject to the same absolute amount in the form of taxes. The principle behind the horizontal equity system is that since the state considers all citizens equal and guarantees them equal legal rights, it must impose the same tax liability on them.
Ability to Pay Principle
The tax burden must be distributed equally among all citizens of a state. The “ability to pay” principle states that the total tax paid by an individual should be proportional to the total wealth they created or their capacity to bear the given tax burden.
Types of Vertically Equitable Taxation Regimes
There are three types of vertical equities: proportional taxation, regressive taxation, and progressive taxation.
1. Proportional taxation
Under proportional taxation systems, all individuals pay the same percentage of their income as income tax. As the wealth of an individual increases, the absolute amount of their tax liability increases proportionately, and vice versa.
2. Progressive taxation
Under progressive taxation regimes, the percentage of income paid as income tax also increases as wealth increases, and vice versa. In a progressive tax system, there are multiple income tax brackets, and individuals are categorized into different brackets after accounting for their annual incomes, capital gains, interest income, employment benefits, etc.
The effective tax rates are the highest for the highest income earners of a particular country, which means that a millionaire pays a higher share of their income in the form of taxes as opposed to a middle-class school teacher.
3. Regressive taxation
Under regressive tax regimes, lower earners pay a higher tax to the state. Regressive taxes no longer exist in modern capitalist society.
Practical Example – Vertical Equity
Under a vertically equitable regime, as followed in the United States, different portions of a taxpayer’s income are taxed at different rates. According to the U.S. Internal Revenue Service (IRS), the first $8,025 earned by a person is taxed at 10%.
The following $24,525 is taxed at a rate of 15%. The next $49,100 is taxed at 25%, and the final $18,350 is levied at 28%. The highest federal tax bracket for any amount of income beyond is 35%.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: