Vertical equity and horizontal inequity: a new approach to measurement

Abstract

A new procedure for measuring horizontal inequity and vertical equity in the income tax is proposed, for which the "equals" under the tax law are socioeconomic groups, and the equal treatment norm is a command that, for equity, these groups should face the same tax schedule. The measures proposed capture the welfare effects of systematic tax discrimination between groups. Horizontal inequity is measured by the dollar value of the welfare loss caused whenever there is tax discrimination between groups. Vertical equity is measured as the dollar value of the welfare gain which comes from the unequal treatment of people at different pre-tax income levels - both between and within the groups. Horizontal inequity is thereby the increment to vertical equity that could be achieved if tax discrimination were eliminated. A distributional judgement parameter is incorporated to take account to be taken of different attitudes to inequality on the part of the social evaluator. The new approach enables answers to be given to many topical questions concerning the way the income tax operates. This is illustrated by an application to Australian data, to investigate whether, and to what extent, the Australian income tax discriminates against wage and salary earners; it caused a roughly one percent loss of social welfare in 1984.