Understanding Horizontal Equity in Taxation

Horizontal equity is an economic theory that is used to assess the fairness of tax burden across a population. The theoretical underpinning of horizontal equity is that the amount of taxes paid should be equal for people in similar circumstances, regardless of the tax system in place. A tax system is considered to be equitable if it reflects the basic principle of equal worth.

Horizontal equity can be compared with vertical equity, which calls for increases in tax rates for higher levels of earned income.

Summary

• Horizontal equity is an economic theory that states that individuals should pay the same tax as those earning the same income.
• Taxpayers’ disposable income and lifetime income are the two commonly used categories to group taxpayers when analyzing the horizontal equity of tax systems..
• A neutral tax system or one that does not give preferential treatment, is considered a horizontally equitable tax system.

Understanding Horizontal Equity

The basic principle of horizontal equity is based on the concept of distributive justice, which posits that taxpayers should contribute the same level of income taxIncome Tax PayableIncome tax payable is a term given to a business organization’s tax liability to the government where it operates. The amount of liability will be based on its profitability during a given period and the applicable tax rates. Tax payable is not considered a long-term liability, but rather a current liability, in proportion to their respective income groups. It means that horizontal equity is premised on an impartial tax system.

Horizontal equity is logical when viewed as equal treatment of equals in taxation so that economic standing is maintained before and after tax. Under the horizontal equity doctrine, some economists use income as the standard approach to group taxpayers as equals and impose proportional taxation as the fair means of distributing the tax burden. However, a taxpayer’s lifetime income is alternatively  considered by some economists as a better measure. The horizontal equity principle can be attained despite the type of income definition used.

Horizontal Equity vs. Vertical Equity

The concept of horizontal equity is used to gauge the fair distribution of tax burden in line with the constitution’s fundamental principle of “equal protection under the law.” Under horizontal equity, individuals in similar situations are accorded the same tax treatment. For example, two individuals earning $25,000 each should contribute the same amount of tax. Therefore, horizontal equity maintains fairness and eliminates discrimination on grounds such as types of work or race.

Comparatively, the concept of vertical equity holds that different amounts of tax should be deducted from different income levels. In effect, it means that, as the disposable incomeDisposable IncomeDisposable Income is the money that is available from an individual’s salary after he/she pays local, state, and federal taxes. It is also increases, a taxpayer pays increased income tax. Vertical equity is in line with the principle benefit of tax, which requires that distribution of tax be in proportion to the benefits from the government.

Vertical equity differs from the ability-to-pay principle based on the fact that the former requires progressive taxProgressive TaxA progressive tax is a tax rate that increases as the taxable value goes up. It is usually segmented into tax brackets that progress to based on income levels. Horizontal equity can be consistent with attaining vertical equity since the equal distribution of tax implies achieving vertically equitable distribution of tax burdens.

Application in Healthcare

Horizontal equity is also defined in the realm of health resource allocation. From such a perspective, healthcare equity refers to the distribution of health resources based on the hierarchy of needs, rather than income differences or class privileges. The perspective arises from the fact that health services can hardly meet every individual’s needs. As with a non-discriminatory tax system, equity into health resources is divided into horizontal and vertical dimensions.

In vertical equity, social members with different levels of needs can receive different amounts of health resources appropriately. Conversely, horizontal equity refers to a situation where individuals with equal needs receive the same health resources. It acts as a measure of health resources allocation in the healthcare system by proposing that those who are equal in different capacities be granted equal healthcare.

Special Considerations

There are situations in which the equal treatment of equals in the taxation principle does not hold. A case in point is income generated from tax-exempt bonds. For example, consider Taxpayers A and B who are equal in all respects. Taxpayer A gets an interest of $9,000 from tax-exempt bonds, while B receives $9,000 as fully taxable interest. Take 30% as the tax rate for illustration, which gives $2,700.

The fact that both taxpayers report the same measured income, it might seem like horizontal equity. However, Taxpayer A owes no tax on the tax-exempt interest, while Taxpayer B will contribute $2,100 on the interest income.

There are also cases where horizontal equity is not applicable – for example, in situations where taxes are levied to account for the external costs. With indifferent tax burdens for tobacco smokers and non-smokers, the standard horizontal equity provides limited applicability.

In such a case, tobacco taxes are intended to compel smokers to shoulder the external costs of smoking; hence, the apparent flouting of the horizontal equity principle is not considered problematic. The concept of horizontal equity is consistently used by policymakers to assess equal sharing of the tax burden in the tax system.

Related Readings

CFI offers the Commercial Banking & Credit Analyst (CBCA)™Program Page - CBCAGet CFI's CBCA™ certification and become a Commercial Banking & Credit Analyst. Enroll and advance your career with our certification programs and courses. certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• Ability-to-Pay TaxationAbility-To-Pay TaxationAbility-To-Pay Taxation (ATP Taxation) is a tax principle that asserts that taxes should be levied based on an individual’s ability to pay the tax. In other
• Negative Income TaxNegative Income TaxNegative income tax is a cash deposit paid by the government to eligible tax residents who are earning below a certain threshold.
• Affordable Care Act (ACA)Affordable Care Act (ACA)The Affordable Care Act (ACA), also known as Obamacare, is a healthcare reform that includes a list of provisions that open opportunities for Americans to
• Universal Basic Income (UBI)Universal Basic Income (UBI)While it does not yet exist as a practical reality in the United States, the concept of a universal basic income – or UBI – is similar to the concept of