The Equity of a Tax System

The Equity of a Tax System

In addition to tax efficiency, another consideration of tax systems is their equity. The equity of a tax system concerns whether the tax burden is distributed fairly among the population.

Vertical equity is the idea that taxpayers with a greater ability to pay taxes should pay larger amounts. Vertical equity is a justification for wealthy people to pay more in taxes than poor people.

Horizontal equity is the idea that taxpayers with similar abilities to pay taxes should pay the same amount. Horizontal equity suggests that a married couple should pay the same amount of taxes as an unmarried couple with the same combined income. In 2004, President George W. Bush initiated a reform of the U.S. tax code that eliminates the penalty on taxpayers who file jointly as a married couple.

Most disagreements about taxation occur because of different opinions about what is fair. According to the benefits principle, it is fair for people to pay taxes based on the benefits they receive from the government. Admission fees for parks are based on the benefits principle. A person who visits a park and pays the admission fee every week would pay more in total park fees over the course of a year than a person who visits the park once a month. Most people consider this fair since the person who visits the park each week probably receives more benefits from the park than the person who visits it less frequently. Taxes on gasoline and diesel fuel are also based on the benefits principle. The income generated by fuel taxes is used primarily to pay for the construction and maintenance of roads and highways. People who drive a lot pay more in fuel taxes over the course of a year than people who drive very little. Most people consider this fair since people who drive a lot receive more benefits from the roads and highways than people who drive very little.

There are some situations, however, in which it is difficult to use the benefits principle. If the government provides additional income for people who cannot afford the necessities of life, it does not make sense to ask the beneficiaries to pay the taxes to fund these transfer payments. Taking $1000 from a low-income family and using it to provide $1000 of income for that family does not increase their net income. Consequently, another principle is used in the construction of many tax systems. According to the ability-to-pay-principle, it is fair for people to pay taxes based on their capability to handle the financial burden. Progressive taxes, such as the individual income tax system in the United States, are based on the ability-to-pay principle. A progressive tax is a tax for which high-income taxpayers pay a larger percentage of their income than do low-income taxpayers. The U.S. individual income tax structure is based on income minus deductions, and the marginal tax rate rises as income rises.

A proportional tax, by contrast, is a tax for which high-income and low-income taxpayers pay the same percentage of income. An example of a proportional tax is a flat tax in which all people pay the same percentage of their income in tax. Flat taxes have been proposed as alternatives to the current individual income tax structure. Proponents of flat taxes argue they have a smaller administrative burden because much less information is needed to calculate them compared to the current individual income tax structure. For the simplest form of a flat tax, the only information needed is total income.

A regressive tax is a tax for which high-income taxpayers pay a smaller percentage of their income than do low-income taxpayers. A lump-sum tax, in which every person pays the same dollar amount, is an example of a regressive tax. A park entrance fee of $10 per person is an example of a lump-sum tax. An example of a poll tax in literature occurs in the story of Robin Hood and his band of merry men who rob or steal from the rich and give the money to the poor. Part of their motivation was that King John imposed a poll tax that required everyone to pay the same amount, regardless of their income. One could argue that Robin Hood considered the poll tax to be unfair because it is not based on the ability-to-pay principle.

The fines for speeding in the United States are not based on a person’s income. Thus, receiving a speeding ticket is a kind of regressive tax. In some European countries, however, the fines vary with the speeder’s income and can be proportional or progressive.

Most sales taxes are regressive. Even though everyone pays a tax that is the same percentage of the purchase price (e.g., 7%), the amount of tax paid is a higher percentage of income for a poor person than a rich person. To illustrate this, consider two people, Chris Cash and Pat Poor, who both buy a portable television with a price of $142.85. Suppose both pay 7% sales tax on their purchases. Thus, each person pays $10 in sales tax on the purchase of the portable television. [($142.85)(.07) = $10]. Suppose Chris has an income of $1000 per week and Pat has an income of $100 per week. The $10 sales tax on the purchase of the television is ten percent of Pat’s weekly income, but is only one percent of Chris’s weekly income. Even though Chris and Pat pay the same dollar amount in sales tax (both pay $10) and both pay the same percentage of the purchase price in sales tax (both pay 7% of the price of the television), the amount of sales tax paid is a larger percentage of Pat’s income than of Chris’s income. Thus, sales taxes are usually regressive.

Social Security taxes are also regressive because they are not paid on incomes above a certain level. For 2004, the income ceiling was $87,900. So someone earning $100,000 or $1,000,000 per year pays the same Social Security tax as someone earning $87,900 per year. This makes the Social Security tax one of the most regressive U.S. taxes.


The following table illustrates progressive, proportional, and regressive taxes for three people with different incomes.

Examples of Progressive, Proportional, and Regressive Taxes

Progressive Tax
Proportional Tax
Regressive Tax

Income
Amount
of Tax
Percent of Income
Amount
of Tax
Percent of Income
Amount
of Tax
Percent of Income
Lee
$ 25,000
$5,000
20%
$6,250
25%
$7,500
30%
Sandy
$50,000
$12,500
25%
$12,500
25%
$12,500
25%
Tracy
$100,000
$30,000
30%
$25,000
25%
$20,000
20%
Table 1. Examples of Progressive, Proportional, and Regressive Taxes


Although people have different opinions about the fairness of tax structures, most people agree they would prefer that someone else pay the taxes. Very few people are eager to pay more taxes. One way everyone can pay less tax is to reduce the size of government. Yet, all governments, regardless of size, must be funded somehow.

In a representative democracy, such as in the United States, elected politicians make governmental decisions on behalf of the people. Politicians tend to be much more popular (1) when they reduce taxes and increase government spending on constituents than (2) when they increase taxes and decrease government spending on constituents. For example, the two most popular U.S. presidents of recent history are Ronald Reagan and George W. Bush. Both Reagan and Bush made tax cuts a major priority in their campaigns and administrations. Presidents George H.W. Bush and Bill Clinton, by contrast, increased taxes during their administrations. Most analysts agree this contributed to a reduction in their popularity.

While cutting taxes may be popular, it might not be fiscally responsible. Proponents of tax cuts usually argue that the increased economic activity (stimulated by the tax cuts) will offset the reduction in tax rates. Opponents of tax cuts usually argue that (1) there will still be a decrease in government revenues even with the increased economic activity, or (2) the tax cuts are directed at the wrong beneficiaries.

A nonpartisan, grassroots organization that promotes fiscal responsibility is the Concord Coalition.[1] The Concord Coalition was founded in 1992 by the late former Senator Paul Tsongas (D-Mass.), former Senator Warren Rudman (R-N.H.), and former U.S. Secretary of Commerce Peter Peterson. Former Senator Bob Kerrey (D-Ne.) was named a co-chair of the Concord Coalition in January 2002.