TPC Tax Topics | Vertical equity

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Vertical equity

Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377

Joseph J. Cordes
George Washington University

A principle used to judge the fairness of taxes, which holds that taxpayers with different incomes should pay different amounts of tax.

Along with horizontal equity, vertical equity is a basic yardstick that is used to gauge whether tax burdens are fairly distributed. The application of the concept of vertical equity differs depending on whether taxes are judged according to the benefit principle or the ability-to-pay principle.

If judgments about tax fairness are based on the benefit principle, and one assumes that the benefits that taxpayers receive from government spending vary with their income, taxation according to the benefit principle would require that taxpayers with different incomes pay different amounts of tax. Depending on how benefits varied with income, however, vertical equity could require that benefit tax burdens be distributed regressively, proportionately, or progressively, depending on whether benefits from public goods and services rose less than proportionately, proportionately, or more than proportionately as income increased.

In contrast to the benefit principle, regressive taxes would not be seen as vertically equitable under the principle of ability to pay. But whether vertical equity under the ability-to-pay standard requires that taxes be proportional or progressive depends on one’s views about the distribution of income. Those who believe that the after-tax distribution of income should be the same as the pretax distribution would favor proportional taxes; those who believe that taxes should help to equalize the distribution of income favor progressive taxes, which narrow the dispersion in the distribution of after-tax incomes. In policy debates about the distribution of the tax burden, there has traditionally been a general, though not universal, presumption that vertical equity requires that tax burdens be distributed at least somewhat progressively.

Vertical equity and consumption income taxation

As in the case of horizontal equity, one issue that arises in applying the concept of vertical equity has to do with the measure of income used to group taxpayers into different income groups. The most common yardstick is annual income, comprehensively measured. Many economists, however, believe that a taxpayer’s lifetime income is a better measure. One’s judgment about whether taxing consumption is inconsistent with vertical equity depends on which definition of income one uses. If the pure version of the life cycle model holds, taxes on consumption will be proportional for lifetime income because current consumption is proportional to lifetime income. The same taxes, however, will generally be regressive for annual income. The reason is that over a taxpayer’s lifetime, consumption tends to be a larger share of income in years when the taxpayer’s annual income is low, and a smaller share in years when income is high.

Application to tax policy

The concept of vertical equity plays an important role in ongoing evaluation of tax policy. Distributional tables, which describe how the benefits of tax cuts or the burdens of tax increases are distributed by income, play an important role in debates about changes in tax law at both the federal and the state levels.

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