Equity

The principle of equity in a tax system is perhaps the most difficult principle to precisely define because it reflects the values of the community, may vary from individual to individual and may change over time. Equity is best considered from a holistic perspective of the tax and transfer system rather than by looking at each component individually. An equitable tax and transfer system does not require that each separate tax and transfer be equitable.

Tax design literature typically discusses 2 types of ‘equity’. The first, called vertical equity, is where those with a higher ability to pay, pay proportionately more tax (or receive fewer benefits). This is also referred to as the progressivity of the tax (and transfer) system. The second, called horizontal equity, involves those with equal ability to pay in fact paying equal tax (or receiving equal benefits), regardless of the source of their income.

Vertical equity

Australia’s personal income tax system is usually described as progressive, as the marginal tax rates increases as your income rises.[43] In combination with the tax-free threshold and low-income tax offset (LITO), this ensures that lower taxable income earners have a lower burden of tax while placing a ceiling on the rate paid for the highest earners (currently 45% for a taxable income of over $190,000, plus the Medicare levy of 2%). It achieves income redistribution, related to the idea of a person’s capacity to pay.

By comparison, a flat income tax on all sources of income applied to everyone would be simpler to administer and arguably more economically efficient but would not achieve the vertical equity of a progressive system.

Horizontal equity

Horizontal equity is achieved when 2 people with the same income (or wealth) pay the same amount of tax and receive equivalent benefits. In practice this is rarely the case due to people’s individual circumstances and the range of personal income, deductions, credits, offsets and exemptions present in the tax system as well as benefits available in the transfer system. Examples include tax arrangements for married couples, home ownership, capital gains tax discount, family tax benefits and childcare subsidies among others. 

Another challenge in achieving horizontal equity involves who has access to benefits under the tax and transfer system. In general, eligibility for benefits delivered through the tax system is based on a person’s taxable income. However, people with significant assets receiving non-wage income have a greater degree of control than a sole wage earner in how much taxable income they receive in a given year. These individuals can structure their income, particularly through a trust.[44] Two people can have the same taxable income, pay varying amounts of tax and receive varying amounts of benefits.

Means testing applies to many direct transfer payments in Australia and involves an individual assessment of a person’s income, assets or both to determine eligibility. Means testing can ensure equity of a transfer payment by limiting access to payments to only those people who the government has determined genuinely need it. Equity concerns can arise when examining which transfer payments governments choose to means test, which assets are included in the means test (as well as the value of those assets) and for which societal groups.

Benefits available to people earlier in their lives such as youth allowance, unemployment benefits and parenting payments are strictly means tested. In contrast, benefits available to older people are less likely to be means tested and if they are, receive significant exemptions such as the principal place of residence for Age Pension assessments.

In this way means testing can be viewed as supporting horizontal equity by ensuring that eligibility for specific transfer payments is consistent.

In practice, the complexity of the tax and transfer system means that both vertical and horizontal equity are difficult to assess.