Tax Equity

This question has probably been around ever since governments started collecting taxes. There are different ways to look at taxes, and as economists, we often use the idea of efficiency. But not now. We are going to talk about tax equity - the fairness of the tax system. It's a tricky question for economists, but doesn't that sound exciting? Let's dig into it.

Tax Equity Definition Economics

What is the definition of tax equity in economics? When we talk about the equity of taxes, we are talking about which people in a society should bear what portion of the tax burden.

Perhaps this is already obvious: tax equity is not a question that economists can fully answer because it also has philosophical aspects. But, we can explain the different approaches to the question using economics. It turns out that there are two principles to consider when we look at tax equity: the benefits principle and the ability-to-pay principle.

Wait a second before you throw this idea out the window, thinking that it is a talking point sponsored by the wealthy who don't want to pay more in taxes. It might be tempting to think that the less wealthy use public services more often, such as public transportation and public schools. But we can also look at it from another perspective. Wealthier people also benefit more from government provisions such as the rule of law. Police and fire services provide greater benefits to the wealthy simply because they have more stuff in need of protection.

In comparison, the ability-to-pay principle is much more straightforward.

It's as simple as that! If you have more wealth, you can afford to pay more in taxes; therefore, you should. No ambiguity here, unlike with the benefits principle.

Vertical Tax Equity

Vertical equity is one way to look at tax equity, and it is related to the ability-to-pay principle.

Vertical Tax Equity: Progressive Tax System

Vertical equity may sound straightforward at first thought, but there is actually some ambiguity. What do we mean by "paying more in taxes"? Does this refer to the absolute amount or in proportion to their income? If we look at tax payments as a proportion of income, we can have three kinds of tax systems: progressive, proportional, and regressive.

Table 1 below shows a progressive tax system.

Table 1 - A progressive tax system example

Table 2 shows a proportional tax system.

Table 2 - A proportional tax system example

Table 3 shows a regressive tax system.

Table 3 - A regressive tax system example

Notice that in Table 3, the higher-income earners still pay more in taxes in absolute amounts in this regressive tax system.

A word of caution, though. Tax payments are only one part of the tax-and-transfer system. We should also consider how much people of different income levels receive from government transfers when we discuss tax equity.

Tax Equity Tax: Horizontal Equity

We can also look at tax equity through the lens of horizontal equity.

It sounds simple, doesn't it? If two taxpayers are similar, their tax payments should also be similar. But in reality, the details are trickier. What do we mean when we say that two taxpayers are similar? Sure, they may have the same monthly income, but does that necessarily mean that their ability to pay taxes is also the same? No, because other factors also matter to the ability to pay taxes.

For example, what if one of them has to raise two children, and the other one doesn't have children? Then, with the same income, the second person can afford to pay more in taxes because he/she doesn't have to spend money on raising two kids. But what if the second person actually has to pay off student debt from college? Now, it is getting harder to say who has a better ability to pay taxes the more factors we consider.

In reality, the tax systems usually take some of these factors into account and treat some of these expenses as "deductibles" - the amount that can be deducted from the amount of taxable income.

Another thing to consider is that income may not be a very good indicator of wealth. For example, a very wealthy person may receive the same amount of annual income as a working professional who receives a pretty good wage but has much less in wealth. Therefore, a wealth tax has been proposed as one way to address this problem and narrow the wealth gap within a country.

Tax Equity Example

We can find examples from different countries where their tax systems take tax equity into consideration.

Tax credits are a common way for governments to give tax relief to a specific group of less well-off taxpayers.

Wealth taxes can be another way to address wealth inequality, but they might be tricky to implement in practice.

An important factor to consider when designing an equitable tax system is the incidence of tax. Consider an example of a sales tax levied on producers. An example of a possible effect of such a tax is shown in Figure 1 below.

Fig. 1 - Tax equity and tax incidence

Figure 1 above shows a tax on a producer which shifts the supply curve from S₀ to S_tax by the amount of tax. However, as the demand for this product is price inelastic, consumers end up paying more of the tax burden than producer does! How is this possible? This is an unintended consequence of this tax policy. The government intended to tax the producer, but consumers ended up paying more because the producers simply passed on the tax to the consumer in form of higher prices. Considering the fact that this product is price inelastic, imagine it also being a necessity. Higher prices would affect consumers on lower incomes disproportionately more than those on higher incomes thereby reducing equity of the tax system!