What Is Vertical Equity in a Tax System?

Vertical equity is a principle of taxation suggesting that individuals who have a greater capacity to pay should contribute a larger percentage of their income or wealth in taxes. This concept structures tax collection so that the tax paid increases as income rises, distributing the burden based on a person’s financial resources.

The Ability-to-Pay Principle

Vertical equity is founded on the ability-to-pay principle, which posits that the tax burden should be allocated according to an individual’s financial capacity. The core of this idea is not about equal dollar amounts but about equal sacrifice, as those with higher incomes can bear a larger tax burden more easily.

A $1,000 tax payment, for instance, represents a significantly different level of financial sacrifice for a person earning $30,000 per year compared to someone earning $300,000. For the lower-income individual, that amount could constitute a substantial portion of their discretionary income, impacting their ability to afford basic necessities. For the higher-income individual, the same $1,000 payment would likely have a much smaller effect on their overall lifestyle and financial stability.

Types of Tax Structures

Tax systems implement vertical equity through several distinct structures, each affecting taxpayers differently based on their income. A progressive tax system is the most direct application of this principle. In this structure, the tax rate increases as a taxpayer’s income increases. For example, a person earning $40,000 might fall into a 12% tax bracket, while someone earning $400,000 could face a marginal rate of 35% or more on their higher levels of income.

A proportional tax, often called a flat tax, applies the same tax rate to all individuals regardless of income. If a flat rate of 15% were in effect, a person earning $30,000 would pay $4,500, and someone earning $300,000 would pay $45,000. While the absolute tax amount increases with income, the percentage of income paid remains constant. This system can be seen as a less stringent form of vertical equity compared to a progressive system.

Conversely, a regressive tax system operates in opposition to the principle of vertical equity. In this structure, the effective tax rate decreases as income increases, meaning lower-income individuals pay a larger proportion of their earnings in taxes. Sales taxes on general goods are often cited as an example, as lower-income households tend to spend a larger percentage of their income on taxed goods, resulting in a higher effective tax rate for them.

Comparison with Horizontal Equity

To fully understand vertical equity, it is useful to contrast it with horizontal equity. Horizontal equity is the principle that taxpayers with similar incomes and financial situations should pay the same amount of tax. The core idea is that “equals should be treated equally” under the tax code.

Vertical equity is concerned with the tax relationship between a person earning $50,000 and another earning $500,000, ensuring the latter pays a proportionately higher tax. Horizontal equity, on the other hand, would be concerned with ensuring two different individuals who both earn $50,000 have a similar tax liability, assuming their financial circumstances are otherwise comparable. In practice, deductions, credits, and tax-exempt forms of compensation can create challenges to achieving true horizontal equity.

Application in the U.S. Tax Code

The United States federal income tax system provides a clear application of vertical equity through its progressive structure. The system uses a series of marginal tax brackets, where different portions of a person’s income are taxed at incrementally higher rates. For the 2024 tax year, for example, the first portion of a single individual’s income is taxed at 10%, the next portion at 12%, and so on, with the top rate reaching 37% for income over a certain threshold.

The tax code also uses other mechanisms to enhance vertical equity. Tax credits, such as the Earned Income Tax Credit (EITC), are specifically designed to reduce the tax liability for low- to moderate-income working individuals and families. The EITC is a refundable credit, meaning that if the credit amount is larger than the taxes owed, the taxpayer receives the difference as a refund. This reduces the tax burden and can supplement income, directing the system’s benefits toward those with a lower ability to pay.