equity in taxation

8/11/2019 Equity in Taxation

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Equity: Two Kinds of Tax Fairness

When people discuss tax fairness, theyre talking about equity. Tax

equity can be looked at in two important ways: vertical equity and

horizontal equity.

Vertical equity addresses how a tax affects different families from the

bottom of the income spectrum to the topfrom poor to rich. Three

terms are used in measuring vertical equity:

Regressive tax systems require that low- and middle-income families

pay a higher share of their income in taxes than upper-income families.

Sales taxes, excise taxes and property taxes tend to be regressive.

Proportional or flat tax systems take the same share of income from

all families.

Progressive tax systems require upper-income families to pay a larger

share of their incomes in taxes than those with lower incomes. Personal

income taxees are usually progressive.

Horizontal equity is a measure of whether taxpayers with similar

circumstances in terms of income, family structures, and age pay similar

amounts of tax. For example, if one family pays much higher taxes than

a similar family next door, that violates horizontal fairness. This sort of

unjustified disparity undermines the public support for the tax system

Equity in Taxation and diminishes peoples willingness to file honest tax returns. It

would

be hard to defend a tax system that intentionally taxed left-handed

people at higher rates than right-handed people. Likewise, a tax that

hits a wage-earner harder than an investor (as the federal income tax

currently does), even if their total incomes are the same, fails the test of

horizontal equity

1. Cost of Service Principle:This principle states that it would be just if people are charged

the cost of the service rendered to them. This principle has no practical application. The cost

of service of armed forces, police, etc.the services which are rendered out of tax proceeds

cannot be exactly determined. Only in those cases, where the services are rendered out of


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of taxation is to be so distributed as to impose equal real burden on the individual tax-

payers. This would mean proportional taxation.

(b) The Principle of Proportional Sacrifice: According to the principle of proportionalsacrifice, the real burden on the individual tax payer is to be not equal but proportional either

to their income or the economic welfare they derive. This would mean progressive taxation.

(c) The Principle of Minimum Sacrifice:The minimum sacrifice principle considers the

body of tax-payers in the aggregate and not individually. According to this principle, the

total real burden on the community should be as small as possible.

(ii) Objective Approach:Under objective approach, a mans faculty to pay may be

measured according to:

(a) Consumption: Consumption, as a criterion of ability to pay, is not a sound criterion,

because consumption or utilisation of the services of the State by the poor is considered to be

out of all proportion to their means, and, as such, it cannot be taken as a practical principle of

taxation.

(b) Property:Property also cannot be a fair basis of taxation, for properties of the same size

and description may not yield the same amount of income; and some persons having no

property to show may have large incomes, whereas men of large property may be getting

small incomes. Thus, to tax according to property will not be taxation according to ability.

(c) Income:Income, however, remains the single best test of a mans ability to pay. Buteven in the case of income, the tax will be in proportion to faculty. The principle of

progression is satisfied under this criterion.

The ability-to-pay principle gives rise to two additional notions of fairness. It seems "fair"

and equitable that those with the same ability to pay should pay the same taxes and those with

different abilities should pay different taxes. More specifically this is termed horizontal

equity and vertical equity.


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Horizontal Equity: This tax equity principle states that people with the same ability to

pay taxes should pay the same amount of taxes. If two people each earn $50,000 of

income, and one pays $5,000 income taxes, a rate of 10%, then horizontal equity

means the other should pay the same $5,000 and 10%.

Vertical Equity: This tax equity principle states that people with a different ability to

pay taxes should pay a different amount of taxes. If one person earns $50,000 of

income and pays $5,000 income taxes, a rate of 10%, then vertical equity means

another person who earns less, say $5,000 of income, should pay fewer taxes, say

$500.

Definition of 'Tax Incidence'

It is an economic term for the division of a tax burden between buyers and sellers. Tax

incidence is related to the price elasticity of supply and demand. When supply is more elastic

than demand, the tax burden falls on the buyers. If demand is more elastic than supply,producers will bear the cost of the tax.

Tax incidence

Tax incidence: Assessing which party (consumers or producers) bears the true burden of a

tax. In economics, tax incidence is the analysis of the effect of a particular tax on the

distribution of economic welfare. Tax incidence is said to "fall" upon the group that

ultimately bears the burden of, or ultimately has to pay, the tax.

Two main concepts of how a tax is distributed:


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a. Statutory incidencewho is legally responsible for tax. Statutory incidence is borne

by those who physically pay the tax. It's what the law says.

b. Economic incidence the true change in the distribution of income induced by tax.

Economic incidence is borne by those who suffer economic loss as a result of the tax.

These two concepts differ because of tax shifting.

A tax has two parts:

(1) A base

(2) Rate structure.

The base is the measure or value upon which a tax is levied. The base can be measures suchas income, sales purchases, home value, corporate profits, etc The tax rate structure is the

percentage of the tax base that must be paid in taxes.

Types of Taxes

A tax can either be proportional, progressive or regressive.

(1) Proportional Tax (Flat Tax): A proportional tax is a tax whose burden is the same rate

regardless of the income earned by the household. For example under a proportional tax

system, if the income tax rate is 13%, then a household who earns $10,000 will pay 13% of

the their income in taxes, while a household who earns $10 million will also pay 13% of

their income as taxes.

(2) Progressive Tax: A progressive tax is a tax that exacts a higher percentage of income from

higher income households than from lower income households. The current income tax

system in the United States is a progressive tax. For example, under a progressive tax system,

a household that earns $10,000 would pay a 5% income tax while a household that earns $10

million would have to pay a 35% income tax.

(3) Regressive Tax: A regressive tax means that higher income households pay less in taxes

as a percentage of their income than lower income families. Excise taxes and retail sales taxes

are examples of regressive taxes.


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Tax Incidence is the division of the burden of a tax between the buyer and the seller. When

an item is taxed, its price might rise by the full amount of the tax, by a lesser amount, or not

at all.

If the price rises by the full amount of the tax, the buyer pays the tax.

If the price rises by a lesser amount than the tax, the buyer and seller share the burden

of the tax.

If the price doesnt rise at all, the seller pays the tax.

When demand is inelastic and supply elastic, tax burden is mainly on the consumer; in case

of inelasticsupply and elastic demand, tax incidence falls mainly on producer.

Progressive taxes are imposed in an attempt to reduce the tax incidence of people with a

lower ability-to-pay; as such taxes shift the incidence increasingly to those with a

higher ability-to-pay.

Regressive taxes tend to reduce the tax incidence of people with higher ability to pay, as

they shift the incidence disproportionately to those with lower ability to pay.

Progressive tax: A tax whose average rate increases as income increases.

Proportional tax: A tax whose average rate is constant at all income levels .

Regressive tax: A tax whose average rate decreases as income increases.

Proportional taxes are straightforward: ratio of taxes to income is constant regardless of

income level.

Can define progressive (and regressive) taxes in a number of ways.

Can compute in terms of

Average tax rate (ratio of total taxes total income) or

Marginal tax rate (tax rate on last dollar of income)

If demand is perfectly inelastic (eD=0), the per-unit tax is completely paid by

demanders

If demand is perfectly elastic (eD=), the per-unit tax is completely paid by suppliers


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