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	Murdoch University Electronic Journal of Law

E LAW - MURDOCH UNIVERSITY ELECTRONIC JOURNAL OF LAW
VOLUME 1 NUMBER 4 (DECEMBER 1994)
Copyright E Law and/or authors

Review of Western Australian State Taxes 1994
Chapter 10 EQUITY

Introduction
Horizontal Equity
Vertical Equity
(1) Club Australia
(2) The Liberal Theory
(3) The Socialist View
Summary
Taxation Incidence
Tax Mix, Government Expenditure and Tax Relief
Conclusion
Bibliography

INTRODUCTION

We have been conditioned to accepting that equity means fairness and has
two dimensions. These two dimensions are common to almost all the
literature on taxation.[1]

Horizontal Equity:
People in similar economic circumstances should be treated similarly.

Vertical Equity:
People in different situations should be treated differently, with a greater share of
the tax burden being borne by those with greater capacity to pay.

Horizontal equity is achieved by equality whereas vertical equity is almost invariably
achieved by inequality and in the latter case the requisite degree of
inequality depends upon the political viewpoint of the observer.

HORIZONTAL EQUITY

Any consideration of equity involves a comparison. The basis for comparison
may not always be clear. For example land tax levied in proportion to the
value of the land held could be said to be horizontally equitable since
land of the same value would attract equal tax. On a wider view it is
horizontally inequitable because a person who holds 10% of their wealth in
land would pay more tax than another who only holds 5% in land. The policy
justification for taxes is commonly derived from distortions induced by
horizontal inequality. For instance, there will also be differences in the
way in which otherwise equal land holdings are held. The existence of land
tax will mean that people will be averse to holding wealth in the form of
unproductive land and the tax will therefore create pressure for land to
gravitate to people who will use it productively to increase their personal
wealth.

VERTICAL EQUITY

Vertical equity is essentially a matter of political judgement. According
to the political inclinations of the observer there are three available
approaches which are fundamentally different. The arguments for each of
them are set out below.

(1) Club Australia

A country is like a golf club. A member must pay the subscriptions. It
makes no difference whether the member is a doctor, lawyer, university
lecturer or unemployed. It is irrelevant whether the member uses the golf
course once a month or six times a week. Similarly the handicap of the
golfer is irrelevant. The determining factor is the rights obtained and not
the rights exercised.

Australia is similar. The services provided by the government are available
to everyone and whether everyone uses them equally is irrelevant. The
services have to be paid for and should be paid for equally by everyone
irrespective of income. If the Australian government needs x amount of
dollars to function then x should be divided by the population of Australia
to arrive at an equitable distribution of tax liability. An example of a
Club Australia philosophy is poll tax.

The Club Australia footprint.
Every person who is liable to pay tax pays the same amount of tax regardless of the persons income e.g. poll tax.

(2) The Liberal Theory

Club Australia theory sounds reasonable but a closer examination reveals
that it is neither practical nor logical.

It is not practical because the services that are provided by government
are so expensive that the tax liability for those on low income would
exceed their income.

The comparison with a golf club is inappropriate because a prospective
member can choose whether to join or not. The same freedom does not apply
to Australian citizenship and the moral considerations are therefore
different.

The function of government is to provide the environment for liberal
pursuits, including the creation of wealth. Therefore, the cost of
maintaining a nation should not be apportioned according to a theoretical
right to participate in national life; rather it should be apportioned
according to the benefits derived from it. The benefit that is derived from
simply living in a country can be assessed by the amount that an individual
earns.

On the assumption that there is a direct correlation between income and
spending, a practical way of doing this is by imposition of a consumption
tax. A person who earns nothing receives nothing and should pay nothing.
Spending increases with income and the tax burden increases
proportionately. If income doubles, benefit derived from the nation doubles
and the contribution to the maintenance of the nation should also double.

Alternatively, it is reasonable to take the view that everyone needs a
certain income simply to exist, ie for food and housing. On this premise it
is reasonable to start taxation at some pre-determined level below which no
tax is paid (a tax threshold). The tax rate would have to be higher to
compensate for tax revenue forgone but nevertheless it would be equitable
because an equitable tax scheme cannot deny any of its citizens the bare
necessities of life. This can be achieved with a flat rate income tax
commencing at a determined threshold level.

Liberal Theory equitable footprints dictate that tax is paid in direct
proportion to income (left e.g. a broad based consumption tax) or, in
direct proportion to income over a certain threshold level (right e.g. a
flat rate income tax commencing after a certain level of income is
obtained).

Liberal Theory equitable footprints dictate that tax is paid in direct
proportion to income (left e

(3) The Socialist View

Liberal theory is an improvement on the Club Australia approach to the
extent that those on higher incomes pay higher taxes. The tax threshold
concept is essential to equity but even the second version of liberal
theory still suffers from two fundamental flaws.

Firstly, the benefit that a person derives from the nation is not in direct
proportion to the amount by which his or her income exceeds subsistence
level. Above subsistence level any funds are used to create comfort. As
wealth increases comfort becomes luxury and eventually raw power by virtue
of the economic system. The greater the excess funds the greater the power
that can be exercised. In order to achieve social equity income which
facilitates lower hierarchal needs should be taxed at a lower rate than
income which tends to satisfy the higher needs.

Secondly, it is a legitimate function of government to redistribute wealth
from the affluent to the poor in the interests of social justice. A
corollary of democratic political theory is that each individual is not
only entitled to a share of political power (the right to vote) but also to
a minimum share to economic power ie a right to a minimum share of the
nation's wealth.

The effect of the socialist view is that vertical equity demands not just a
flat tax scale but a progressive tax scale to achieve fairness. This can be
achieved by taxing income above a threshold level at incremental rates
determined by gross income.

The equitable footprint of socialists. The greater the income the greater
the amount of disposable income (that left after paying for necessities).
Tax rate rises with income.

Summary

The above analysis is argued as a progression from the political right to
the left. All the arguments are based on the proposition that taxation
should be structured according to the benefits principle.[2] This assumption
is tenuous: there are cogent social and political arguments for divorcing
the two concepts.Furthermore, assessment of the equity of a tax may also
have to take into account the incidence of a tax and the expenditure scheme
of the tax collected.

TAXATION INCIDENCE

The burden of taxation may not remain at the point where it is imposed. The
classical example is the imposition of a tax on the production of a good.
If demand for widgets is inelastic consumers will continue to buy them and
bear the tax. As elasticity increases demand will decrease if the tax is
passed on so the supplier will have to bear a higher tax burden.

Elasticity may be the result of consumers doing without the type of good or
service taxed but, more commonly, it is largely dependant upon the
availability of substitute goods or services which are not subject to the
tax. If such goods or services exist, a horizontal inequity is produced
which results in market distortion measured by elasticity. To reduce the
effects of distortion (and reduce elasticity) the tax base must be
increased to include substitute goods.

Broadening the tax base does not necessarily mean covering all aspects of
an economy; it is only necessary to cover the economic sector that is being
taxed. For example, if a tax is imposed on deposits in bank accounts a
horizontal inequity is produced which distorts behaviour by inducing
greater use of building societies and credit unions. Horizontal equity can
be restored by taxing the universe of financial institutions. If horizontal
equity exists within the sector the only options left to consumers are to
pay the tax or exit the sector and return to cash transactions. Because of
the convenience of cheques and electronic transfers the effect of the
second option will be minimal.

TAX MIX, GOVERNMENT EXPENDITURE AND TAX RELIEF

Analysis of any existing tax can only be of academic (or political)
interest until that analysis is integrated into the overall tax mix and the
effects of government expenditure and tax relief (or breaks) are
considered.

There may be instances where vertical inequity occurs with respect to a
particular tax but the inefficiency and revenue loss involved with
redressing the inequity is prohibitive. Since the underlying function of
taxation is to provide money for government, removing the tax is not a
viable option.

There are three ways of compensating for such inequities:

i) adjusting a more flexible tax to induce an inequity approximately equal
and opposite to the first tax;

ii) direct government expenditure to people adversely affected by the tax;

iii) creating tax relief (breaks) to people adversely affected.

For example, consider an economic entity with no welfare payments and a
government which obtains its revenue entirely through progressive rate
income tax with a tax free threshold. The equitable footprint of this
strategy would be similar to a country which relies largely on a
consumption tax for government revenue but supplements low income earners
with transfer payments and has a greater tax threshold and a greater
difference between the lowest income tax rate and the highest.

This is not to say that any consideration of a proposed tax in isolation is
without merit. Analysis of the equity of the new tax or an increase in an
existing tax will provide useful information for predicting the effect on
the overall tax mix.

CONCLUSION

Horizontal equity analysis is useful for predicting economic distortions
and the vertical equitable footprint can be compared with the existing tax
mix footprint to assess the impact of the tax with respect to notions of
social justice. However, both concepts may have to take government
expenditure into account in order to complete the picture.

BIBLIOGRAPHY

BAUMOL, W.J., & BLINDER, A.S., Economics: Principles and Policy, 5th Ed,
Harcourt, Jovanovich and Brace, Florida, 1991.

COMMONWEALTH OF AUSTRALIA, Reform of the Australian Tax System: Draft White
Paper (Canberra: Australian Government Printing Service, 1985).

[1] For example see: "Reform of the Australian Tax System" Draft White Paper,
June, 1985, paragraph 1.2.

[2] Baumol, W.J., & Blinder, A.S., Economics: Principles and Policy, 5th Ed,
Harcourt, Jovanovich and Brace, Florida, 1991, 704.