Equity: Two Kinds of Tax Fairness

When people discuss tax “fairness,” they’re talking about equity. Tax
equity can be looked at in two important ways: vertical equity and
horizontal equity.
Vertical equity addresses how a tax affects different families from the
bottom of the income spectrum to the top—from poor to rich. Three
terms are used in measuring vertical equity:
■ Regressive tax systems require that low- and middle-income families
pay a higher share of their income in taxes than upper-income families.
Sales taxes, excise taxes and property taxes tend to be regressive.
■ Proportional or flat tax systems take the same share of income from
all families.
■ Progressive tax systems require upper-income families to pay a larger
share of their incomes in taxes than those with lower incomes. Personal
income taxe es are usually progressive.
Horizontal equity is a measure of whether taxpayers with similar
circumstances in terms of income, family structures, and age pay similar
amounts of tax. For example, if one family pays much higher taxes than
a similar family next door, that violates “horizontal” fairness. This sort of
unjustified disparity undermines the public support for the tax system
Equity in Taxation and diminishes people’s willingness to file honest tax returns. It
be hard to defend a tax system that intentionally taxed left-handed
people at higher rates than right-handed people. Likewise, a tax that
hits a wage-earner harder than an investor (as the federal income tax
currently does), even if their total incomes are the same, fails the test of
horizontal equity

1. Cost of Service Principle: This principle states that it would be just if people are charged
the cost of the service rendered to them. This principle has no practical application. The cost
of service of armed forces, police, etc. – the services which are rendered out of tax proceeds –
cannot be exactly determined. Only in those cases, where the services are rendered out of
prices, e.g., supply of electricity, railway or postal service, a near approach can be made to
charging according to the cost of service.

2. Benefit of service or Quid Pro Quo Theory: This theory suggests that the taxes should
be levied according to the benefit conferred on the tax-payers. But its practical application is
also difficult. Most of the public expenditure is incurred for common or indivisible
benefits. It is impossible to calculate how much benefit accrues to a particular
individual. There are a few cases only where the benefit to one individual is ascertainable,
e.g., old-age pensions. The benefit theory violates the basic principle of tax. A tax is paid for
the general purposes of the State and not in return for a specific service. Moreover, it is
commonly believed that the poor benefit more from the State activities than the rich. If that
is so, then the poor has to contribute more than the rich. This would be absurd. However, the
idea of benefit stands out prominently in the case of fees, licences, special assessment and
local rating.

The benefit principle states that taxes should be based on the benefits received, that is, those
who receive the greatest benefits should pay the most taxes. On the surface, this principle is
quite logical and easily justified. The people who benefit from public goods are logically the
ones who should pay for their provision. Drivers should pay for highways, library patrons
should pay for libraries, students should pay tuition, camping enthusiasts should pay for
national parks, and the list goes on.

3. Ability to Pay or Faculty Theory: This is the most popular and the plausible theory of
justice in taxation is that every tax-payer should be made to contribute according to his ability
or faculty to pay. The difficult task is to determine a person’s ability to pay tax. There are
two approaches for this theory – subjective and objective:

(i) Subjective Approach: In the subjective aspect, the inconvenience, the pinch or the
sacrifice bear by tax-payer is considered. There are three distinct views in this regard:

(a) The Principle of Equal Sacrifice: According to J.S. Mill, equality of taxation, as a
maxim of politics, means equality of sacrifice. According to this principle, the money burden
of taxation is to be so distributed as to impose equal real burden on the individual tax-
payers. This would mean proportional taxation.

(b) The Principle of Proportional Sacrifice: According to the principle of proportional
sacrifice, the real burden on the individual tax payer is to be not equal but proportional either
to their income or the economic welfare they derive. This would mean progressive taxation.

(c) The Principle of Minimum Sacrifice: The minimum sacrifice principle considers the
body of tax-payers in the aggregate and not individually. According to this principle, the
total real burden on the community should be as small as possible.

(ii) Objective Approach: Under objective approach, a man’s faculty to pay may be
measured according to:

(a) Consumption: Consumption, as a criterion of ability to pay, is not a sound criterion,
because consumption or utilisation of the services of the State by the poor is considered to be
out of all proportion to their means, and, as such, it cannot be taken as a practical principle of

(b) Property: Property also cannot be a fair basis of taxation, for properties of the same size
and description may not yield the same amount of income; and some persons having no
property to show may have large incomes, whereas men of large property may be getting
small incomes. Thus, to tax according to property will not be taxation according to ability.

(c) Income: Income, however, remains the single best test of a man’s ability to pay. But
even in the case of income, the tax will be in proportion to faculty. The principle of
progression is satisfied under this criterion.

The ability-to-pay principle gives rise to two additional notions of fairness. It seems "fair"
and equitable that those with the same ability to pay should pay the same taxes and those with
different abilities should pay different taxes. More specifically this is termed horizontal
equity and vertical equity.
 Horizontal Equity: This tax equity principle states that people with the same ability to
pay taxes should pay the same amount of taxes. If two people each earn $50,000 of
income, and one pays $5,000 income taxes, a rate of 10%, then horizontal equity
means the other should pay the same $5,000 and 10%.

 Vertical Equity: This tax equity principle states that people with a different ability to
pay taxes should pay a different amount of taxes. If one person earns $50,000 of
income and pays $5,000 income taxes, a rate of 10%, then vertical equity means
another person who earns less, say $5,000 of income, should pay fewer taxes, say

Definition of 'Tax Incidence'

It is an economic term for the division of a tax burden between buyers and sellers. Tax
incidence is related to the price elasticity of supply and demand. When supply is more elastic
than demand, the tax burden falls on the buyers. If demand is more elastic than supply,
producers will bear the cost of the tax.
Tax incidence
Tax incidence: Assessing which party (consumers or producers) bears the true burden of a
tax. In economics, tax incidence is the analysis of the effect of a particular tax on the
distribution of economic welfare. Tax incidence is said to "fall" upon the group that
ultimately bears the burden of, or ultimately has to pay, the tax.
Two main concepts of how a tax is distributed:
a. Statutory incidence – who is legally responsible for tax. Statutory incidence is borne
by those who physically pay the tax. It's what the law says.
b. Economic incidence – the true change in the distribution of income induced by tax.
Economic incidence is borne by those who suffer economic loss as a result of the tax.
These two concepts differ because of tax shifting.
A tax has two parts:
(1) A base
(2) Rate structure.
The base is the measure or value upon which a tax is levied. The base can be measures such
as income, sales purchases, home value, corporate profits, etc… The tax rate structure is the
percentage of the tax base that must be paid in taxes.
Types of Taxes
A tax can either be proportional, progressive or regressive.
(1) Proportional Tax (Flat Tax): A proportional tax is a tax whose burden is the same rate
regardless of the income earned by the household. For example under a proportional tax
system, if the income tax rate is 13%, then a household who earns $10,000 will pay 13% of
the their income in taxes, while a household who earns $10 million will also pay 13% of
their income as taxes.
(2) Progressive Tax: A progressive tax is a tax that exacts a higher percentage of income from
higher income households than from lower income households. The current income tax
system in the United States is a progressive tax. For example, under a progressive tax system,
a household that earns $10,000 would pay a 5% income tax while a household that earns $10
million would have to pay a 35% income tax.
(3) Regressive Tax: A regressive tax means that higher income households pay less in taxes
as a percentage of their income than lower income families. Excise taxes and retail sales taxes
are examples of regressive taxes.
Tax Incidence is the division of the burden of a tax between the buyer and the seller. When
an item is taxed, its price might rise by the full amount of the tax, by a lesser amount, or not
at all.
 If the price rises by the full amount of the tax, the buyer pays the tax.
 If the price rises by a lesser amount than the tax, the buyer and seller share the burden
of the tax.
 If the price doesn’t rise at all, the seller pays the tax.

When demand is inelastic and supply elastic, tax burden is mainly on the consumer; in case
of inelastic supply and elastic demand, tax incidence falls mainly on producer.
Progressive taxes are imposed in an attempt to reduce the tax incidence of people with a
lower ability-to-pay; as such taxes shift the incidence increasingly to those with a
higher ability-to-pay.
Regressive taxes tend to reduce the tax incidence of people with higher ability to pay, as
they shift the incidence disproportionately to those with lower ability to pay.
Progressive tax: A tax whose average rate increases as income increases.
Proportional tax: A tax whose average rate is constant at all income levels.
Regressive tax: A tax whose average rate decreases as income increases.
Proportional taxes are straightforward: ratio of taxes to income is constant regardless of
income level.
• Can define progressive (and regressive) taxes in a number of ways.
• Can compute in terms of
– Average tax rate (ratio of total taxes total income) or
– Marginal tax rate (tax rate on last dollar of income)
• If demand is perfectly inelastic (e
=0), the per-unit tax is completely paid by
• If demand is perfectly elastic (e
=), the per-unit tax is completely paid by suppliers