The concept is that “unequals should be taxed unequally” and the higher your income, the higher your tax bill should be. Vertical equity goes hand-in-hand with the theory of horizontal equity, which states that “equals should be taxed equally.” Vertical equity is the basis of the United States’ progressive income tax system. This system holds that those who earn more should contribute more to the country’s public services because they can afford to do so. Thus, their top tax rate is a more significant percentage of their earnings. Progressive taxation is enforced through tax brackets. Each bracket has a different tax rate, with higher-income brackets paying the highest tax rates. A progressive tax system is the opposite of a regressive tax system, wherein those who earn less pay a greater portion of their incomes to taxation. Sales tax is a prime example of a regressive tax because individuals who earn less must pay more of their incomes toward the tax than those who earn more.
How Tax Breaks Affect Vertical Equity
The concept of vertical equity can be complex because you don’t have to pay income tax on every single dollar you earn, thanks to provisions like tax deductions. And the vertical equity theory works on taxable income, not gross income—what you earn before claiming deductions and other tax breaks. Tax breaks and deductions can skew the vertical equity concept a bit because they can lower your tax liability. You and your neighbor might pay the same tax rate even though they earn $15,000 more a year than you do. If they qualify for and use more tax deductions, they might be able to eliminate that $15,000 difference by subtracting available deductions. Your neighbor might be able to afford a more expensive home than you and thus pay more mortgage interest, which they can deduct. Or perhaps your neighbor provides annual charitable donations, also considered an itemized deduction, thus decreasing their tax liability. The end result is that you have fewer deductions, so you and your neighbor might have similar taxable incomes. Standard deductions, unlike itemized deductions, are not vertical. They’re the same for everyone based on their filing status, regardless of income. Both you and your neighbor could shave the same amount off your gross income—$12,950 in tax year 2022 if you’re both single—and pay the applicable tax rate on the balance.
An Example of Vertical Equity
The U.S.’s progressive tax system is a good example of vertical equity. If you’re single, the portion of your income over $41,775 and up to $89,075 would be taxed at 22% in tax year 2022. Say you make $80,000 of taxable income annually. In this case, you would pay 22% on the top $38,225 of your income—the difference between $75,000 and $41,775. Your income that falls below this threshold is taxed at a lesser rate. Now let’s say that your neighbor earned $95,000 of taxable income in 2022. Their portion of their income over $89,075—$5,925—would be taxed at 24%. This is vertical equity in action. The portion between $40,525 and $86,375 would be taxed at 22%, just as your top dollars are.
Vertical Equity vs. Horizontal Equity
The theory of horizontal equity is effectively an extension of vertical equity. It states that those in the same income group should pay the same tax rate.
