Tax Equity: Study with Video Lessons, Practice Problems & Examples

Tax equity involves fairness in the tax system, guided by two principles: the benefits principle and the ability to pay principle. The benefits principle states that those who benefit from services should pay taxes, exemplified by gasoline taxes funding road maintenance. The ability to pay principle suggests that individuals should pay taxes based on their disposable income, promoting vertical equity where higher earners pay more. Tax systems include regressive, proportional, and progressive taxes, with progressive taxes increasing as income rises, aligning with the ability to pay principle and ensuring equitable tax burdens.

Tax Equity

So the government needs to design a tax system that's going to be efficient, but that it's also going to be fair. Let's discuss tax equity in this video. Tax equity deals with the fairness of the tax system. It helps us answer these types of questions like how should the tax burden be divided? How do we judge if it's fair? So we're going to discuss 2 main principles when it comes to tax equity. The first one here being the benefits principle. The benefits principle says that people who receive the benefits, if you receive the benefits, you should pay the taxes. If you're going to receive the benefit, you should pay the tax. So there's a couple of examples here. The first one being a gasoline tax. This is a very common tax example for the benefits principle. So what's the benefit of the gasoline tax? They're going to put a tax on gasoline and then they're going to use that money to fix roads, right? They might use the tax revenue to fix potholes, right, maintain the roads in general and who's going to pay for it? Well, the people who use the roads. The people who drive are going to buy gasoline, maybe not if you have a Tesla, but in general, people who drive are going to pay for the gasoline and that money is going to be used to fix and maintain the roads. Another example here is a marina. So if there's a marina, a tax for using the marina, well, what's the benefit? Maybe they'll raise this tax revenue and they'll maintain the waterways, right? They'll maintain the waterways. It's common here in Miami for people who own boats and stuff like that; maybe I'll join them one day. So the marina tax, people who use the marina, who dock their boats at the marina, they're going to pay a tax and that money is going to be used to maintain the waterways, clean the ocean. So who's going to pay it? The people who use people with boats, right? People with boats who use the waterways, they're going to pay that tax. So this follows the benefits principle, right? Who is benefiting from the tax is paying the tax. Cool? Nothing too crazy there. Let's talk about the next one, the ability to pay principle. So this is that people who should pay taxes, they should pay taxes based on how easily they can afford it. In general, this means that if you have a lot of disposable income, well, you should have a little extra to pay more taxes. So poor people should not have to pay as much tax because it's going to be more of a burden to them. They're going to have to sacrifice more to pay some taxes here. So the idea about the ability to pay is that you should make an equal sacrifice to pay taxes. So let's look at these three different situations. The first person, they're making $10,000 and they have to pay $1,000 of tax. Right? This is a $1,000 tax on a 10,000 income. So we would say they're paying about 10% of their money in taxes. So what's their disposable income? This is the money they have left after they pay taxes. Well, that's going to be the 10,000 - 1,000. That leaves them with 9,000 in disposable income. Right? So notice they're still paying taxes, but they only have 9,000 left in disposable income. Now, what if someone with $50,000 only had to pay $1,000 of tax? So now a $1,000 of tax on 50,000, they're only paying 2% of their money in taxes. Right? So their disposable income, well, they have 50,000 and they only have to pay 1,000 in tax. They're left with 49,000 of disposable income. And we could say that they have a lot more disposable income here, right? That first 9,000 that the previous person had, well, they're probably going to have to spend that on rent, on food. Well, this person, if they spent the same amount, they'd still have another 40,000 left over. Now what about a $10,000 tax on 50,000 of income? So 10,000 on 50,000. Notice here they're paying 20% in taxes, but how much disposable income are they left with? They've got 50,000 minus the 10,000. They're still left with 40,000 in disposable income. Right? So even though they're paying a lot more taxes, they're paying 10,000 while the first person is only making 10,000, they still have a lot more disposable income. They still have a lot more luxuries they can afford even though they ended up paying more taxes. So what this does is it suggests that more taxes should be raised from people with higher incomes than lower incomes. This is what the ability to pay principle says because when you're not making a lot of money, it's a big sacrifice to pay a lot of taxes, right? Because you don't have a lot of money to begin with. When you have a lot of money, well, you can sacrifice a little more and it's not as big of a deal to you. This principle, the ability to pay principle, goes hand in hand with what we call vertical equity. The taxpayers with higher income pay more taxes, right? As you make more money, you should pay more taxes. This is vertical equity, right? You can afford more taxes because you're making more money. Now let's compare that to this other idea of horizontal equity. So this is the idea that people in the same economic situation should pay the same amount of taxes. Notice vertical equity, we're talking about equity going up and down the line of people making more money should pay more taxes because they can afford it. However, horizontal is people in the same situation should pay the same amount of taxes. So let's look at these 2 people. This is kind of an ethical question here. Look, the sick family so we've got the sick family. They're earning $100,000. They have no children and they pay $40,000 in medical expenses. While the school family, they also earn $100,000. They have 4 children and they pay $60,000 in tuition. So notice, it's very difficult to have horizontal equity here. Right? Because they're not in very similar situations but they're both burdened in similar ways. Right? They still while the sick family, their problem is that they have a lot of medical expenses, the school family, well, they have a lot of school expenses. Right? They have a lot of tuition expenses. So are they in the same economic situation? Not really. But how do we they're both still burdened quite a bit here. Right? So which one of them should receive a tax break? These are those ethical questions that come into play when we design a tax system, right? Should there be a tax break because they have a lot of medical expenses? Should there be a tax break because there are a lot of tuition expenses? These are the questions that need to be answered when designing a tax system and that's how we deal with the horizontal equity. Okay? So let's pause here and we'll discuss, the 3 types of taxes here, that we'll see in the next video. The regressive, proportional and progressive tax. Cool? Alright. Let's go ahead and do that in the next video.

Regressive, Proportional, and Progressive Taxes

So now let's discuss some tax systems where you're going to see increasing taxes as you make more money. Now the first one, the regressive tax system, the tax rate actually decreases as income increases. In most cases, this still generally ends up in higher taxes paid, but if it's regressive enough, if the tax rate is decreasing enough, it actually ends up where they're paying less taxes, where people making more money are paying less taxes, right? And obviously, that wouldn't follow the tax equity principles we've been discussing so far. But we'll see what a regressive tax looks like. The next one, a proportional tax. Well, the tax rate is going to stay the same. It's going to stay proportional as income increases, and a progressive tax. This is more what we have in the USA. The USA has a progressive tax system and that's where the tax rate increases as income increases. So that's something where the first bit of money you make is taxed at a certain percentage and as you make more money, the percentage is going to keep increasing. Okay? So let's go ahead and discuss these three different systems here. So we're going to see 3 incomes, someone making $50,000, $100,000, $200,000. Okay? And let's discuss regressive tax. So in the first situation, we're going to see that there's going to be a regressive tax where there's going to be 20% tax and then notice, regressive. It's going to be decreasing as you make more money. 15% tax and then 10% tax as you go up in income, right? As the income increases, the tax rate is decreasing. So how are we going to calculate these taxes? Well, we've got a very simple tax system here. So we're just going to have to multiply across here. We'll multiply the tax rate times the income and that's going to give us the amount of taxes paid. So the amount of tax for the $50,000, if they're paying 20%, $50,000 times 20%, that's $10,000 in taxes. $100,000 times 15%, that comes out to $15,000 and $200,000 times 10%. Well, $200,000 times 10%, that's $20,000. Notice that the amount of tax is increasing still, right? It's because they're making more money and even though they're paying a less percentage, that amount of tax is still increasing. Now, if these percentages had been different, yes, we could have had a situation where the $200,000 person was paying less taxes than the $100,000. But in general, this is how we're going to see how these tax rates flow. Okay? Now proportional tax. Now the tax rate's going to be the same for everybody. So if everyone had a 15% tax rate, right? The middle tax rate here, the 15% for everybody, well, notice that although you're making more money, you have to pay more taxes because you're still paying taxes on all that extra money you're making. So $50,000 times 15%, that comes out to $7,500; $100,000 times 15%, that's $15,000 in taxes, and finally, $200,000 times 15%, that's $30,000 in taxes. So there you go. You see the taxes increasing? Well, they made more money and they're paying that same 15% on the more money they made. So naturally, they're going to have to pay more taxes. And now a progressive tax system. So notice this is like the opposite of the regressive tax system. In this case, we're going to have the 10% here for the $50,000 earner, 15% and then 20%. So as you make more money, you're going to have to pay a higher percentage of your income. So, the $50,000 times 10%, they're going to pay $5,000 in taxes. $100,000 times 15%, they're going to pay $15,000. And finally, the $200,000 times 20%, that goes up to $40,000. But remember, this goes with the discussion of the ability to pay. Right? Although they have a lot more money and they're paying more in taxes, they still end up with more disposable income, right? They have a lot more money left over after they pay taxes. So this is the discussion on tax equity, right? It usually comes down to that idea that as you make more money, you pay more taxes because you have the ability to make the sacrifice while still having plenty of disposable income left over. Cool? So that's the idea of tax equity. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the benefits principle in tax equity?

The benefits principle in tax equity states that those who benefit from public services should pay the taxes that fund those services. For example, a gasoline tax is used to maintain roads, and those who buy gasoline (and thus use the roads) pay this tax. Similarly, a marina tax might be used to maintain waterways, with boat owners who use the marina paying the tax. This principle ensures that the cost of public services is borne by those who directly benefit from them, promoting fairness in the tax system.

What is the ability to pay principle in tax equity?

The ability to pay principle in tax equity suggests that individuals should pay taxes based on their ability to afford them. This means that those with higher disposable incomes should pay more in taxes, as they can more easily bear the financial burden. For example, someone earning $50,000 might pay a higher percentage of their income in taxes compared to someone earning $10,000. This principle promotes vertical equity, where higher earners contribute more to the tax system, ensuring a fair distribution of the tax burden.

What is the difference between vertical and horizontal equity in tax systems?

Vertical equity in tax systems means that taxpayers with higher incomes should pay more in taxes, reflecting their greater ability to bear the financial burden. This aligns with the ability to pay principle. Horizontal equity, on the other hand, suggests that taxpayers in similar economic situations should pay the same amount in taxes. This principle aims to ensure fairness among individuals with comparable financial circumstances, even if their specific expenses (like medical bills or tuition) differ.

What are the differences between regressive, proportional, and progressive tax systems?

In a regressive tax system, the tax rate decreases as income increases, meaning higher earners pay a smaller percentage of their income in taxes. A proportional tax system applies the same tax rate to all income levels, so everyone pays the same percentage of their income. A progressive tax system, like that in the USA, increases the tax rate as income rises, meaning higher earners pay a larger percentage of their income in taxes. Progressive taxes align with the ability to pay principle, ensuring that those who can afford to pay more do so.

How does a progressive tax system align with the ability to pay principle?

A progressive tax system aligns with the ability to pay principle by increasing the tax rate as income rises. This means that individuals with higher incomes pay a larger percentage of their income in taxes. For example, someone earning $200,000 might pay 20% in taxes, while someone earning $50,000 might pay 10%. This ensures that those who can afford to pay more do so, reducing the financial burden on lower-income individuals and promoting fairness in the tax system.