Chapter 2
Tax Policy Issues: Standards for
a Good Tax
“The art of taxation consists in so
plucking the goose as to obtain the
largest possible amount of feathers
with the least possible amount of
hissing.”
Jean Baptiste Colbert
Horizontal Equity
 Horizontal Equity
 Achieving horizontal equity depends heavily on the tax base
definition.
 Tax ‘loopholes’ vary across taxpayers.
 A simple but unpopular solution is to eliminate all tax preferences.
This solution would likely increase the current systems’ horizontal
equity but at the expense of the economic or social benefits derived
from activities that tax preferences are designed to promote.
 In other words, horizontal equity may conflict with regulatory use of
tax policy
 E.g., deduction for charitable contributions encourages taxpayers to invest
in their communities
 Denial of a deduction for fines and penalties discourages taxpayers from
engaging in behavior that government otherwise penalizes
 Accelerated depreciation deductions encourage investment in new
equipment or other business use property (by subsidizing the cost of such
investment)
Vertical Equity
 Vertical Equity
 What should rate structure look like?
 In the current political/economic climate, the policy issue
is usually not whether rich should pay more taxes than
poor, but how much more is appropriate. The
determination of “how much more” those with higher
incomes should pay may result in a tax rate structure that
is regressive, proportional, or progressive.
Vertical Equity
 Regressive: tax rate decreases as tax base increases.
 Smith pays $2,000 tax (10%) on income of
$20,000 and Jones pays $3000 tax (5%) on
income of $60,000.
 Proportional = flat tax rate
 Smith pays $2,000 tax (10%) on income of
$20,000, and Jones pays $6000 tax (10%) on
income of $60,000.
 Progressive: tax rate increases as tax base increases.
 Smith pays $2000 tax (10%) on income of
$20,000, but Jones pays 12,000 (20%) on income
of $60,000.
Rate Structure
 Tax Rate Structure
 Average Tax Rate = total tax paid by tax base (typically
gross income or taxable income)
 Marginal Tax Rate = The rate of tax applied to the next dollar
of taxable income.
 In a progressive rate structure this rate increases as
income levels increase.
 In a proportionate rate structure average and
marginal rates are the same.
Historical U.S. Individual Tax Rates
Top Marginal Individual Income
Tax Rates