Vertical equity is a tax theory dictating that taxpayers in different income groups should be taxed at different percentages. The concept is that “unequals should be taxed unequally” and the higher your income, the higher your tax bill should be. Vertical equity goes hand in hand with the theory of horizontal equity, which states that "equals should be taxed equally."
Creating more vertical equity for taxpayers was the goal of the Tax Reform Act of 1986. It’s a reasonable theory on the surface, but it doesn’t guarantee that you and your neighbor will pay the same amount in federal taxes, even if your incomes are the same dollar for dollar.
Definition and Example of Vertical Equity
The principle behind vertical equity is that those who earn more should be subject to a higher tax percentage, while those who earn less should be subject to a lower percentage.
Let’s look at an example of how this works. If you’re single, the portion of your income over $40,525 but less than $86,375 would be taxed at the rate of 22% in tax year 2021. Say you make $75,000 annually. In this case, you would pay 22% on the top $34,475 of your income—i.e., the difference between $75,000 and $40,525. Your income that falls below this threshold is taxed at a lesser rate.
Now let’s say that your neighbor earned $90,000 in 2021. Their income is over $86,375, so they would be taxed at a higher percentage of 24%. But the portion between $40,525 and $86,375 would be taxed at 22%, just as your top dollars are. They pay a higher percentage income only over that $86,375 threshold.
A Component of a Progressive Tax System
Vertical equity is the basis of the progressive income tax system in place in the U.S. This system holds that those who earn more should contribute more to the country’s public services because they can afford to do so. Thus, their top tax rate is a more significant percentage of their earnings.
Progressive taxation is enforced through tax brackets. Each bracket has a different tax rate, with higher-income brackets correlating to those who have to pay the highest percentage in taxes.
A progressive tax system is the opposite of a regressive tax system, wherein those who earn less pay a greater portion of their incomes to taxation.
The sales tax is a prime example of a regressive tax because individuals who earn less must pay more of their incomes toward this type of flat tax. It’s the same for all consumers across the board, regardless of income. They all pay 2% on the same purchase, but someone earning $90,000 annually can well afford to pay 2% of $100. Someone earning $15,000, however, would more likely feel the pinch of 2% of a $100 purchase.
How Vertical Equity Works
The concept of vertical equity can be complex. This is because you don’t have to pay income tax on every single dollar you earn, thanks to provisions like tax deductions. And the vertical equity theory works on taxable income, not gross income—the entirety of what you earn before claiming deductions and other tax breaks. This is the income upon which you're taxed.
Tax breaks and deductions can skew the vertical equity concept a bit because they can lower your tax liability. You and your neighbor might pay the same tax rate even though they earn $15,000 more a year than you do. If they can spend more on expenses that are tax deductible, they might be able to whittle that $90,000 down to $75,000 by subtracting available deductions.
You might not be able to afford to pay the same expenses on your earnings, so you would lose those tax deductions. For instance, home mortgage interest is an itemized deduction, but your neighbor might be able to afford a more expensive home than you and thus pay more in interest on their loan annually. Or perhaps your neighbor provides annual charitable donations, also considered an itemized deduction, thus decreasing their tax liability.
The end result is that you have fewer deductions, so you and your neighbor might pay income tax on comparable earnings.
Some tax deductions come with built-in phaseouts, prohibiting taxpayers who earn over a certain threshold from claiming them, or at least from claiming the full deduction that lesser-earning taxpayers might be entitled to.
Standard deductions, unlike itemized deductions, are not vertical. They’re the same for everyone based on their filing status, regardless of income. Both you and your neighbor could shave the same amount off your gross income—$12,550 in 2021 if you’re both single—and pay the applicable tax rate on the balance.
Vertical Equity vs. Horizontal Equity
The theory of horizontal equity is effectively an extension of vertical equity. It states that those in the same income group should pay the same tax rate.
|Vertical Equity||Horizontal Equity|
|Taxes different income groups at different rates||Taxes similar income groups at the same rate|
|Higher earners pay a greater percentage of taxes on their top dollars||Strives for equality between high and low earners by minimizing tax incentives|
You and your neighbor would pay the same tax rate in the scenario outlined above if you both had taxable income of $75,000, even after they were able to claim more deductions. The major difference between vertical and horizontal equity is that horizontal equity attempts to reduce or eliminate the impact of tax incentives that may favor certain wealthier taxpayers. It strives to remove this inequity, which is not always possible due to the exceptions that exist.
The alternative minimum tax reflects the concept of horizontal equity because it applies to those who earn more than certain thresholds. It limits some tax breaks for high earners. They must calculate their tax obligation in two ways on income over an allowed exemption amount, then pay whichever tax result is more.
- Vertical equity is a tax theory that requires taxpayers in different income groups to be taxed at different percentages, with those who earn more having to pay a higher percentage of their incomes in taxes.
- The progressive tax system is based on vertical equity, and it dictates tax brackets in the U.S. by which lower earners are taxed at a lesser percentage.
- Brackets are applied to taxable income, not gross income (what is left over after you take all available deductions).
- Wealthier earners can sometimes be privy to more deductions that can significantly reduce their taxable incomes.