Vertical Equity
What is Vertical Equity?
Vertical equity is the tax principle that people with greater ability to pay should bear a larger tax burden, usually through a rising average tax rate.
Vertical equity comes out of the ability-to-pay principle, and the usual argument for it is diminishing marginal utility of income: a dollar taken from a household with plenty costs less welfare than a dollar taken from one with little, so equal sacrifice implies heavier rates higher up the income scale. Governments deliver it through graduated marginal rate brackets, a standard deduction or personal exemption that zeroes out tax at the bottom, refundable credits and means-tested transfers. The limit of the principle is that it sets a direction, not a number: equal absolute sacrifice, equal proportional sacrifice and equal marginal sacrifice each imply a different rate schedule, and none of them is obviously the right one. Raising top rates also enlarges deadweight loss and invites avoidance and reduced hours, so how much progressivity is optimal turns into an empirical question about behavioral responses rather than a matter of principle. Statutory rates can mislead too, since payroll tax ceilings, preferential rates on capital income and consumption taxes all shift the effective burden away from what the headline bracket table suggests.
Vertical Equity: a worked example
Take a schedule with a zero rate on the first $15,000 of income, 15 percent from $15,000 to $60,000, and 32 percent above $60,000. A worker earning $40,000 pays 0.15 times ($40,000 minus $15,000) = $3,750, an average rate of 3,750 divided by 40,000 = 9.4 percent. A worker earning $200,000 pays 0.15 times $45,000 = $6,750 on the middle band plus 0.32 times $140,000 = $44,800 on the top band, for $51,550 in total, an average rate of 51,550 divided by 200,000 = 25.8 percent. The average rate climbs from 9.4 percent to 25.8 percent as income rises, so the schedule satisfies vertical equity. Notice also that the higher earner's marginal rate of 32 percent sits well above her 25.8 percent average rate.
The mistake students make with vertical equity
Paying more dollars in tax gets treated as proof of vertical equity. Under a flat 20 percent rate, someone earning $200,000 pays $40,000 while someone earning $50,000 pays $10,000, four times as much in dollars, yet both face a 20 percent average rate, so the system is proportional rather than progressive. Vertical equity in its standard reading requires the average rate to rise with income, not just the dollar amount. The related slip is confusing the marginal rate with the average rate when judging how progressive a schedule is.
Vertical Equity questions
What is the difference between vertical equity and horizontal equity?
Horizontal equity says people in the same economic position should pay the same tax, while vertical equity says people in different positions should pay appropriately different amounts. A tax code can satisfy one and fail the other. A progressive rate schedule riddled with deductions that only some taxpayers can use may still raise average rates with income, meeting vertical equity, while letting two people with identical incomes pay very different bills, which breaks horizontal equity.
Does vertical equity require a progressive income tax?
In its standard reading, yes: the burden should rise more than proportionally with ability to pay, which shows up as an average tax rate that climbs with income. The principle does not say how fast it should climb, though, and progressivity can be delivered through transfers and refundable credits rather than through the rate schedule alone. A country with a single flat rate and a large refundable credit can end up more progressive overall than one with graduated brackets and generous deductions for high earners.
Are sales taxes and value-added taxes bad for vertical equity?
Measured against annual income, a uniform consumption tax is regressive, because lower-income households spend a larger share of their income and therefore hand over a larger share of it in tax. Measured against lifetime consumption the regressivity shrinks, since income saved today gets taxed when it is eventually spent. Countries that lean on value-added taxes usually restore some vertical equity by zero-rating food and medicine, or by paying cash rebates targeted at low-income households.
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