Vertical Equity Definition & Examples

Published Sep 8, 2024

Definition of Vertical Equity

Vertical equity is a principle of fairness in economics that suggests individuals with a greater ability to pay should contribute more to society, typically through taxes. This concept holds that the tax system should take into account individuals’ income levels and overall wealth when determining their tax obligations. In essence, vertical equity seeks to achieve fairness by imposing a higher tax burden on those with higher income or wealth, thereby ensuring that those who are more capable of contributing do so to a larger extent.

Example

Let’s consider a progressive tax system to illustrate vertical equity. In this system, individuals earning between $0 and $20,000 per year are taxed at a rate of 10%. Those earning between $20,001 and $50,000 are taxed at a rate of 20%, and those earning above $50,000 are taxed at a rate of 30%.

Here’s how it works in practice:

Individual A earns $15,000 annually and pays $1,500 in taxes (10% of $15,000).
Individual B earns $35,000 annually and pays $7,000 in taxes (20% of $35,000).
Individual C earns $70,000 annually and pays $21,000 in taxes (30% of $70,000).

In this example, Individual C pays more in taxes both in absolute terms and as a percentage of their income compared to Individual A and Individual B. This differential taxation based on ability to pay is a reflection of vertical equity.

Why Vertical Equity Matters

Vertical equity is crucial for the following reasons:

Social Fairness: It aims to reduce income inequality by ensuring that wealthier individuals contribute a fairer share of taxes, which can be used to fund social services and safety nets for the less fortunate.
Economic Efficiency: By aligning tax burdens with individuals’ capacity to pay, vertical equity can potentially reduce the economic strain on lower-income households, allowing them to spend more on necessities and contribute to economic growth.
Sustainable Public Finance: Progressive taxation based on vertical equity can provide a stable and sustainable source of revenue for governments, helping to fund public goods and services without disproportionately affecting lower-income groups.

Frequently Asked Questions (FAQ)

What are the different methods used to achieve vertical equity in tax systems?

Various methods are employed to achieve vertical equity in tax systems, including:

Progressive Taxation: Tax rates increase with higher income levels, as seen in progressive income tax systems.
Luxury Taxes: Higher taxes on luxury goods, which are primarily consumed by wealthier individuals.
Estate and Inheritance Taxes: Taxes levied on the transfer of wealth upon death, aimed at reducing inherited wealth inequalities.
Capital Gains Taxes: Higher tax rates on capital gains, which typically benefit wealthier individuals more.

Are there any criticisms or limitations of vertical equity?

Yes, while vertical equity aims to achieve fairness, it does face several criticisms and limitations:

Disincentives for High Earners: High tax rates on wealthy individuals may discourage them from working harder or investing, potentially slowing economic growth.
Administrative Complexity: Progressive tax systems can be complex to administer and enforce, leading to increased government expenditure and potential loopholes.
Tax Evasion and Avoidance: Wealthy individuals may seek ways to evade or minimize their tax liabilities, undermining the effectiveness of vertical equity.
Economic Distortions: High taxes on capital gains or corporate profits may lead to inefficiencies and reduced investment in the economy.

How does vertical equity differ from horizontal equity?

Vertical equity and horizontal equity are both principles of fairness in taxation but differ in their focus:

Vertical Equity: Focuses on the principle that those with higher income or wealth should pay more in taxes.
Horizontal Equity: Emphasizes that individuals with similar ability to pay should contribute the same amount in taxes, ensuring equal treatment for taxpayers in comparable financial situations.

While vertical equity addresses fairness through the lens of income disparity, aiming to reduce inequality, horizontal equity seeks consistency and fairness among those at the same economic level. Effective tax systems often strive to balance both principles to achieve overall fairness in taxation and social justice.