What Determines Tax Fairness in a Tax System?

Tax fairness is a central theme in public policy, questioning how to equitably distribute the tax burden. The debate revolves around who should pay, how much they should contribute, and what criteria define a just system for funding government services, as there is no single, universally accepted definition.

Perspectives on tax fairness are shaped by economic and social philosophies. Some arguments prioritize an individual’s right to their wealth, while others focus on the collective good and using taxes to redistribute resources. This dialogue seeks to balance the government’s need for revenue with creating a system that citizens perceive as just.

Core Principles of Tax Equity

The ability-to-pay principle is a core concept in tax fairness. It posits that an individual’s tax contribution should be related to their financial resources. Those with a greater capacity to pay should contribute more to funding public services than those with fewer resources.

Vertical equity builds on this principle, stipulating that taxpayers with a greater ability to pay should contribute a higher percentage of their income. For example, a person earning $500,000 annually would be expected to pay a larger proportion of their income in taxes than someone earning $50,000. This concept addresses the relative tax burden across different income levels.

Horizontal equity asserts that taxpayers in similar financial situations should face a similar tax burden. This means two individuals with the same income and number of dependents should pay an identical amount of tax. However, achieving pure horizontal equity is challenging, as the tax code contains provisions that create different outcomes for people with identical incomes.

Major Tax Structures and Fairness

Tax systems are designed around three primary structures, each with different implications for fairness. In a progressive tax system, the tax rate increases as income increases. This structure applies the principle of vertical equity by requiring higher earners to contribute a larger percentage of their income. The U.S. federal income tax, with its tiered tax brackets, is a primary example.

A regressive tax system is the opposite, where the effective tax rate decreases as income increases. This system imposes a proportionally greater burden on lower-income individuals. A general sales tax is a common example, as it consumes a larger share of income from lower-income households who spend more of their money on necessities.

A proportional tax system, or “flat tax,” applies a single tax rate to all taxpayers regardless of income. This structure achieves horizontal equity, as those with the same income pay the same amount. The debate around a flat tax centers on vertical equity, as it does not require higher earners to contribute a greater percentage of their income.

Analyzing the US Tax System

The United States employs a mix of tax structures, making the system neither purely progressive nor regressive. The federal income tax is the system’s most prominent progressive component. It uses marginal tax brackets where income in higher brackets is taxed at higher rates. For 2024, these rates range from 10% to 37%.

Payroll taxes, which fund Social Security and Medicare, introduce a regressive element. The 6.2% Social Security tax applies only up to an annual income limit ($168,600 for 2024). Earnings above this cap are not taxed, so high-income earners pay a smaller percentage of their total income toward Social Security. The Medicare tax of 1.45% applies to all earnings, with an additional 0.9% for incomes above $200,000 for single filers, adding a progressive element.

State and local governments add regressive pressure with sales and property taxes. Because lower-income households spend a larger portion of their income on goods and services, sales tax constitutes a higher percentage of their earnings. Property taxes can also be regressive, as property value is not always a direct indicator of a household’s current ability to pay, which is especially true for retirees or those with fluctuating incomes.

The tax treatment of investment income also impacts the system’s equity. Long-term capital gains and qualified dividends are taxed at preferential rates of 0%, 15%, or 20% (for 2024), which are lower than rates for ordinary income. Because higher-income individuals derive a larger share of their income from investments, this treatment reduces their effective tax rate and works against vertical equity.

The Role of Tax Expenditures

Tax expenditures—special provisions like deductions, credits, and exclusions—also influence the system’s fairness. These provisions result in government revenue loss and alter the amount of income subject to tax. They function like direct spending to encourage certain behaviors or provide relief to specific groups.

Tax expenditures directly impact horizontal equity by creating situations where two taxpayers with identical incomes pay different amounts in taxes. For example, if two families earn $100,000, but one deducts mortgage interest while the other rents, the homeowners will have a lower tax liability.

These provisions also affect vertical equity, with many disproportionately benefiting higher-income taxpayers. Deductions are more valuable to those in higher tax brackets; a $1,000 deduction saves a taxpayer in the 37% bracket $370, but only $120 for one in the 12% bracket. The deduction for state and local taxes (SALT) and preferential capital gains rates are other examples that benefit wealthier individuals.

Conversely, some tax expenditures are designed to assist low- and middle-income families. The Earned Income Tax Credit (EITC) is a refundable credit for workers with low to moderate income. The Child Tax Credit also provides financial relief to families. These credits make the tax system more progressive, but their impact is weighed against other expenditures that favor the wealthy.

Global Perspectives on Tax Fairness

Tax systems in other developed nations provide a broader context on fairness. Many European countries rely on a Value-Added Tax (VAT), a consumption tax collected at each stage of production. A VAT can be regressive, but many countries mitigate this by applying lower rates or exemptions for essential goods like food and medicine.

Some countries also implement wealth and inheritance taxes to address wealth concentration. These taxes are more common in some European nations than in the U.S. and are levied on a person’s assets, not just their income, to reduce large generational wealth transfers. The design of these taxes varies widely, sparking debate about their economic impact.

Global approaches to corporate and capital gains taxes also differ, reflecting varying priorities between attracting investment and ensuring equitable contributions. Corporate tax rates vary significantly across developed countries. Some nations align capital gains tax rates more closely with those on ordinary income to improve vertical equity. These comparisons show that tax fairness is a dynamic concept, with each country balancing its own economic and social goals.