Those who are tasked with analyzing and instituting tax policies are often charged with determining whether the systems in place are fair. In this regard, there are two primary types of equity distributions to consider: horizontal equity and vertical equity.
Horizontal equityHorizontal equity is based on the idea that those who have the same amount of wealth, or similar levels of income, should be taxed at the same rate as others within that same income bracket. For example, if two people earn $50,000 and receive the same tax bill of $10,000, then the system is considered horizontally equitable.
Horizontal equity can be difficult to achieve when a tax system, like that of the U.S., has loopholes and deductions, because when tax breaks are introduced, it creates a situation where individuals earning similar amounts of money do not wind up paying the same taxes. For example, because the U.S. tax code allows mortgage interest to be deducted from income, the IRS is essentially allowing for a difference in tax payments among filers who earn the same amount.
Vertical equityVertical equity is based on the idea that those who earn more money, or have more economic resources, should be taxed at higher rates than those earning less money. The idea is that those who have the means to pay more taxes should contribute at higher rates than those who do not. For example, if someone who earns $50,000 is subject to a 10% tax rate and someone who earns $100,000 is subject to a 20% tax rate, then the system is considered vertically equitable.
Proponents of this system believe that wealthier individuals benefit more from government services and should therefore be responsible for paying more to support them. They might argue, for example, that because tax dollars are used to pay for police services, and wealthy people have more assets to lose in the event of a robbery, they should be the ones to pay higher taxes.
Vertical tax systems generally fall into one of three categories:
- Regressive taxes, where lower earners lose a higher percentage of their income to taxes compared to those with higher incomes
- Proportional taxes, where the same tax rate is imposed regardless of income
- Progressive taxes, where the tax rate rises as an individual's income increases
The U.S. employs a progressive tax system in which earners fall into tax brackets based on their earnings. Those in higher income tax brackets owe a greater percentage of their earnings to taxes, whereas those who earn less owe a smaller percentage of their earnings to taxes.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us firstname.lastname@example.org. Thanks -- and Fool on!
The article Horizontal vs. Vertical Equity originally appeared on Fool.com.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright 1995 - 2016 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.