Question

How would you apply the principles of horizontal and vertical equity in deciding how much to tax two people, each capable of doing the same work, but one of whom chooses to devote more time to sunbathing and therefore has a lower income?

Short answer

The higher earner pays more taxes, reflecting vertical equity, while identical tax principles apply due to their identical earning capabilities under horizontal equity.

Step-by-step solution

Understanding Equity Principles

Equity principles in taxation are guidelines for ensuring that the tax system is fair and just. Horizontal equity refers to the idea that individuals with similar income or ability to pay should be taxed similarly. Vertical equity proposes that individuals with a greater ability to pay should contribute more to the tax system.

Analyzing the Scenario

In this scenario, two people have the same capability for work, but one earns less because they choose to spend more time sunbathing. According to horizontal equity, because they have the same earning potential, they should ideally be taxed in a similar manner based on income. However, their actual income differs due to their personal choices.

Applying Horizontal Equity

To apply horizontal equity effectively, both individuals should be taxed similarly for their similar ability to work. In this case, they should be taxed equally if the tax system considers potential income rather than actual income. However, most tax systems consider actual income.

Applying Vertical Equity

According to vertical equity, the individual with the higher income and greater ability to pay should contribute more in taxes. Therefore, despite similar work capabilities, the person who chooses to work more and earns a higher income should pay more taxes.

Decision on Taxation

Considering both principles, a balance needs to be struck. The person who earns more should pay more taxes due to their higher income according to vertical equity. The individual with lower income, who chooses more leisure, would pay less taxes corresponding to their actual income level.

Key concepts

Horizontal Equity

Horizontal equity in taxation emphasizes the fair treatment of taxpayers with similar financial circumstances. This principle suggests that if two individuals have the same income or ability to pay, they should be taxed in a comparable manner. The core idea is to ensure equality across similar economic situations.
For instance, imagine two people with the same earning capabilities. If their actual earnings are the same, horizontal equity dictates that their tax burdens should also be the same. However, complications arise when external factors affect these similarities, such as personal lifestyle choices that result in different actual earnings.
Despite this, horizontal equity strives to maintain fairness by aligning tax burdens with individuals' comparable economic potential whenever possible.

Vertical Equity

Vertical equity involves the principle that those with higher incomes or greater financial capabilities should pay more in taxes. It provides a moral framework suggesting that tax contributions should increase with the ability to pay. This creates a more progressive tax system where wealthier individuals contribute more to society's financial requirements.
When applied to situations where individuals have equal potential but different incomes, vertical equity prescribes that the higher earner must contribute more due to their increased income. Thus, it emphasizes fairness by considering the disparity in financial capabilities and seeks to balance society's overall welfare by redistributing wealth from those with more to those with less.

Income Tax

Income tax is a levied charge on the earnings of individuals and businesses to fund government services and infrastructure. The taxation system can track earnings from various sources like wages, salaries, interest, dividends, and more.
Income tax forms the backbone of public finance, making critical services like healthcare, education, and transportation possible.
A crucial aspect of income tax is its flexibility to incorporate both horizontal and vertical equity principles. By adjusting tax rates and identifying taxable income levels, governments strive to implement fair taxation. The primary goal of income tax is to ensure adequate public revenue while maintaining equity among taxpayers.

Tax Fairness

Tax fairness is an overarching concept that ensures just and equitable distribution of tax burdens among individuals. This notion goes beyond merely fulfilling revenue goals, focusing instead on maintaining social harmony and economic justice.
Fair tax systems must embody horizontal and vertical equity, thus appropriately meeting different individual capabilities and circumstances.
Achieving tax fairness requires a delicate balance in the tax structure. It should neither burden low-income individuals excessively nor exempt high-income individuals disproportionately. Hence, a fair tax system is both reasonable in its demands and equitable in its application to preserve societal trust and economic stability.