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Tax Equity

Who should pay more in taxes?

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.

Tax equity is the concern about the fairness of how the tax burden is distributed.

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.

The benefits principle says that how much people pay in taxes should be based on how much they benefit from the goods and services that government provides.

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.

The ability-to-pay principle says that people should pay taxes based on how well they can shoulder the tax burden.

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 equity means that people who can afford to pay more in taxes should pay more in taxes.

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.

PersonIncome ($)Tax Payment ($)% of Income
A5,00050010%
B10,0001,50015%
C30,0007,50025%

Table 1 - A progressive tax system example

A progressive tax system is where a person with a higher income pays a larger proportion of their income in taxes than a person with a lower income.

For an overview, take a look at our explanation: Progressive Tax System.

Table 2 shows a proportional tax system.

PersonIncome ($)Tax Payment ($)% of Income
A5,00075015%
B10,0001,50015%
C30,0004,50015%

Table 2 - A proportional tax system example

A proportional tax system is where everyone pays the same proportion of their income in taxes regardless of their income level.

Table 3 shows a regressive tax system.

PersonIncome ($)Tax Payment ($)% of Income
A5,00075015%
B10,0001,20012%
C30,0003,00010%

Table 3 - A regressive tax system example

A regressive tax system is where a person earning a higher income pays a smaller proportion of their income in taxes than a person with a lower income.

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.

The tables above show a simplistic tax system with one tax rate for the person's entire income.

In reality, a person's income is taxed at different marginal tax rates for different portions of the income.

To learn more, read our explanation: Marginal Tax Rate.

Stated Tax Rates vs. Effective Tax Rates

It might be hard to see how such a brazen regressive tax system can be accepted by the general public. In reality, a regressive tax system can be less obvious. For example, a de-facto regressive tax system can exist even if the stated tax rates are higher for people with higher incomes. This can be due to the greater number of tax deductions and other tax loopholes that are available to higher-income earners. In other words, higher-income earners face lower effective tax rates than those with a lower income in such a tax system.

Tax Equity Tax: Horizontal Equity

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

Horizontal equity is the idea that people with a similar ability to pay taxes should pay a similar amount of taxes.

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.

Of course, each country's tax system is a little different from that of another country. You can learn more about the tax systems in the US and the UK by reading our explanations:

- US Tax

- UK Taxes

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.

A wealth tax, or a net wealth tax, is an annual tax on the assets that a person owns above a certain threshold minus the person's debts.

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.

Child Tax Credit in the US 1

In the aftermath of the coronavirus pandemic, the US passed the American Rescue Plan, which included a provision to expand the child tax credit to reduce child poverty. It increased the amount of the tax credit and expanded access to new families. The tax credit was also made fully refundable so that low-income families could receive the full benefit even if their income tax payments were lower than the amount of the tax credit.

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

Wealth Taxes in Some OECD Countries

Wealth taxes were once more popular than they are today. In 1990, there were 12 OECD countries with a net wealth tax. Over the years, this number has dropped to only 3. 2 As of 2022, only Norway, Switzerland, and Spain have a net wealth tax. In addition to these three, France, Italy, and Belgium have wealth taxes on selected assets. In particular, France replaced its net wealth tax with a tax on real estate in 2018; Italy taxes financial assets and real estate held abroad; Belgium taxes securities accounts worldwide. 3

The difficulty in enforcing that all assets are declared and taxed properly can mean that a wealth tax is less effective than it is hoped to be. In addition, in some countries, the wealth taxes started from a relatively low threshold. This meant that the middle class had been taxed, which made the taxes politically unpopular. Another concern for a wealth tax is that it taxes assets irrespective of their returns, which can make the tax regressive in practice if people holding less liquid assets, which do not generate too much income, are taxed. 2

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.

Tax Equity Graph of Tax equity and tax incidence StudySmarterFig. 1 - Tax equity and tax incidence

Figure 1 above shows a tax on a producer which shifts the supply curve from S0 to Stax 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!

Of course, you can read up more on other tax-related topics on StudySmarter!

Check out the following explanations:

- Deadweight Loss

- Tax Compliance

- Lump Sum Tax

- Incidence of Tax

Tax Equity - Key takeaways

  • Tax equity is the concern about the fairness of how the tax burden is distributed.
  • The benefits principle says that how much people pay in taxes should be based on how much they benefit from the goods and services that the government provides.
  • The ability-to-pay principle says that people should pay taxes based on how well they can shoulder the tax burden.
  • Vertical equity means that people who can afford to pay more in taxes should pay more in taxes.Horizontal equity means that people with a similar ability to pay taxes should pay a similar amount of taxes.

References

  1. US Department of the Treasury. "Child Tax Credit." https://home.treasury.gov/policy-issues/coronavirus/assistance-for-american-families-and-workers/child-tax-credit
  2. Economics Observatory. "Why did some earlier wealth taxes fail and could this time be different?" https://www.economicsobservatory.com/why-did-some-earlier-wealth-taxes-fail-and-could-time-be-different
  3. Tax Foundation. "Wealth Taxes in Europe." https://taxfoundation.org/net-wealth-tax-europe-2022/

Frequently Asked Questions about Tax Equity

Tax equity is the concern about the fairness of how the tax burden is distributed. 

There are two principles to consider when we look at tax equity: the benefits principle and the ability-to-pay principle. 


The benefits principle says that how much people pay in taxes should be based on how much they benefit from the goods and services that government provides. 


The ability-to-pay principle says that people should pay taxes based on how well they can shoulder the tax burden. 


A progressive tax system is where a person with a higher income pays a larger proportion of their income in taxes than a person with a lower income. 

Horizontal equity is the idea that people with a similar ability to pay taxes should pay a similar amount of taxes.

Vertical equity means that people who can afford to pay more in taxes should pay more in taxes.

Final Tax Equity Quiz

Question

What is tax equity?

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Answer

Tax equity is the concern about the fairness of how the tax burden is distributed.

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Question

What does the benefits principle say about taxes?

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Answer

The benefits principle says that how much people pay in taxes should be based on how much they benefit from the goods and services that government provides.

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Question

What does the ability-to-pay principle say about taxes?

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Answer

The ability-to-pay principle

says that people should pay taxes based on how well they can shoulder the tax burden.

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Question

The idea that people who can afford to pay more in taxes should pay more in taxes is called _____.

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Answer

Vertical equity.

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Question

The idea that people with a similar ability to pay taxes should pay a similar amount of taxes is called ______.

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Answer

Horizontal equity.

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Question

Which of the following can support the idea that Bill Gates should pay more in taxes than you do?

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Answer

Vertical equity.

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Question

What is a progressive tax system?

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Answer

A progressive tax system is where a person with a higher income pays a larger proportion of their income in taxes than a person with a lower income.

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Question

A regressive tax system taxes someone with a lower income at _____.

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Answer

a higher proportion.

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Question

What is a proportional tax system? 

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Answer

A proportional tax system is where everyone pays the same proportion of their income in taxes regardless of their income level.

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Question

Which of the following are ways to address equity concerns of taxes?

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Answer

Designing a progressive tax system.

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Question

A net wealth tax taxes a person's _____.

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Answer

Assets minus liabilities.

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Question

Which of the following is bad from the perspective of tax equity?

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Answer

Imposing a wealth tax on people's second house.

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Question

Which of the following is good from the tax equity perspective?

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Answer

Giving the Child Tax Credit to poorer families.

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Question

From the perspective of equity, which of the following should be taxed at a higher rate?

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Answer

Personal computers.

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Question

From the perspective of equity, which of the following should the government do?

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Answer

Giving tax credits for student loan payments.

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