Vertical Equity Definition Example Vertical Vs Horizontal Equity

Vertical Equity Definition

Types of Vertical Equity

Tax is charged in two different ways under the vertical equity method viz.

Progressive TaxationProportional Taxation

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#1 – Progressive Taxation

Under progressive taxationProgressive TaxationProgressive tax refers to the increase in the average rate of tax with the increase in the amount of taxable income so that the liability of paying heavy taxes passes to those who earn a higher income and those with lower income can have a relaxation from the heavy income tax obligations.read more, the average tax rate increases as the income of a person increases. The income of an individual is charged using various tax brackets, each bracket will have a different tax rate i.e. higher the annual income of an individual higher is the tax bracket.

Suppose the income of an individual is $ 100,000 and the tax slabs/brackets are as follows,

0 – $ 50,000 = 10%$ 50,001 – $ 100,000 = 20%above $ 100,000 = 30%

Therefore as per the above example, the tax of the individual would be under-slab 1 and 2 i.e. income up to $ 50,000 will be taxed at 10% which will come to $ 5,000 and the remaining $ 50,000 ($ 100,000 – $ 50,000) will be taxed at 20% i.e. $ 10,000. So the total tax will be $ 15,000.

#2 – Proportional Taxation

Under the proportional taxProportional TaxA proportional tax is a single-rated tax in which all incomes are taxed at a flat fixed rate regardless of the type of person or type of income, removing the concept of greater and lower earnings.read more method, the income is charged at a single rate irrespective of the income class of the tax payee.

The tax rate is flat 10% for all income groups i.e. a person earning $70,000 annually will pay a tax of $7,000 and a person earning $250,000 annually will have to pay $25,000. Therefore we can see here that the principle of vertical equity is being followed as the individual with the higher income is paying more tax to the government.

Example of Vertical Equity

Country A has the progressive tax structure in place and the slabs are as below,

Up to $ 10,000 = 5%$ 10,001 – $ 20,000 = 10%above $ 20,000 = 30%

The income of John for the financial year is $ 60,000 we are required to calculate the tax on the same.

Solution

Here the income of John is $ 60,000, which makes him part of all 3 slabs. It is important to understand the fact that income of $ 60,000 doesn’t mean that entire income will be charged at 30%, it means income above $ 20,000 will be charged at 30% rate, i.e. in our example, the income of $ 40,000 will be charged at 30%, $ 10,000 will be charged at the rate of 10 % and balance $ 10,000 at 5%.

Therefore the tax for Mr. John will be = 40,000 * 30% + 10,000 * 10% + 10,000 * 5% = $ 13,500

Vertical Equity vs Horizontal Equity

The concept of Horizontal EquityHorizontal EquityHorizontal equity is a tax treatment that a particular class of individuals who earn the same income should also pay the same income tax. There should be no discrimination between any two persons regarding their savings, expenditure, and deductions claimed but should be leviable with the same income tax.read more states that individuals with the same income or assets classAssets ClassAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples.read more should be charged the same amount of taxes i.e. “equal treatment for equals”. This means if two individuals earn an income of $ 30,000 per annum, both should pay tax amounting to $ 3,000 only. Whereas the concept of Vertical Equity states that higher the income of the individual higher would be the average tax rate. It works on the principle that those who earn more should pay more.The horizontal Equity method is difficult to apply in the economy where there are various tax benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.read more like rebatesRebatesA rebate is a cashback to the customers against the purchase as a completing transaction incentive. Rebates are offered after the sale. Thus, it is a form of marketing strategy provided to the client to facilitate future transactions.read more, tax credits, deductions, exemptions, etc. due to such benefits there will be inequality of tax amount despite the income for people being the same i.e. if one person gets a deduction for payment of housing loan then he will get a lower amount of tax as compared to the one who hasn’t paid any housing loan. This will make the horizontal equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company’s balance sheet.read more method ineffective.

Conclusion

Vertical equity is a system where more tax is paid by an individual as the income increases.Tax is charged using two methods viz. Progressive Taxation and Proportional taxationIt is easy to implement as compared to Horizontal equity for an economy where there are multiple tax benefits like tax credits, exemptions, deductions, etc.