The terms “horizontal equity” and “vertical equity” are used in the context of social policy rather than finance. Horizontal equity refers to the idea that people in the same circumstances should be treated in the same way. Vertical equity refers to the idea that people on higher incomes should take on a greater share of the responsibility for paying for public services.
The Principle of Horizontal and Vertical Equity
Horizontal equity and vertical equity are relevant in investing because they often influence taxation policies. The concepts of horizontal equity and vertical equity date back to the works of Aristotle and Plato. They have become increasingly relevant in recent years.
Horizontal equity aims to produce a tax system whereby those on the same income pay the same amount in tax. Most countries, including the USA, take horizontal equity as a starting point for their taxation systems. It can, however, become very difficult to maintain horizontal equity as soon as tax-deductible expenses are introduced.
In some cases, there are compelling justifications for compromising horizontal equity in the tax system. For example, some medical expenses can be tax-deductible. This creates tax inequality, but also helps individuals in very challenging circumstances.
In other cases, the deductibles can be more of a grey area. For example, mortgage interest, property taxes, and pension contributions can be tax-deductible. This places homeowners and those on higher incomes at a clear advantage over renters and lower earners. But all of these measures help people to prepare for their later years.
Enabling people to be financially self-sufficient in their “silver period” benefits both the individual and society. The former is more likely to enjoy being as independent as possible for as long as possible. The latter is less likely to have to provide and finance a high level of support for them.
Vertical equity aims to ensure that those who earn more pay more. It is compatible with horizontal equity because it is still possible for people in the same situations to be treated in the same way. Vertical equity is also often known as “progressive taxation” because tax levels progress upwards along with income.
It is much easier to implement the concept of vertical equity on income-based taxes than it is on asset-based taxes. This is because income is liquid, whereas assets are not. Some assets can be monetised at least to some extent. For example, you may be able to rent out a room in your home.
This may not be a serious issue with certain asset classes, e.g. precious metals. In the real world, however, the single biggest asset most people own is their home. Homes tend to appreciate in value, hence would incur a higher level of taxation under a vertical equity system.
The occupants’ income, however, might not have risen in line with the value of their home. In fact, it might even have reduced. For example, a person might have paid off their mortgage and retired. If vertical equity raised property taxes beyond what they could afford, they would be forced to sell their home and move, with all that implies.
What is the difference between equity and equality?
The concepts of equity and equality both aim to achieve fairness. They are, however, very different in their approaches to achieving fairness.
Equity focuses on outcomes. It allows for people to be treated differently as long as the end effect of this treatment is to bring them to the same outcome. Equality, by contrast, focuses on requiring people to be treated equally regardless of circumstances. For example, it prevents discrimination on the basis of arbitrary criteria such as race.
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