Equity Effects of Taxation

Entities equally placed prior to the imposition of a tax may find themselves to be unequally affected by the imposition of the tax. Thus, a tax could be inequitable across different consumers and producers in the economy, that is, it may suffer from ‘horizontal inequity’. Also, a tax may exacerbate the inequity that already exists in the income distribution in the economy. This indicates that the tax suffers from ‘vertical inequity’. The design of taxes should prevent worsening the prevailing distribution of income in the population. There are alternative criteria behind how taxes are imposed. One is the benefit principle, that is, a tax should be collected from a taxpayer in reflection of the benefit he derives from a public service. It does not recognise equity as a principle but has certain advantages such as transparency. Another method is taxing according to the ability to pay of a taxpayer that results in higher taxation as incomes rise. Yet another method is optimal taxation that emphasises the efficiency criterion with built-in subsidies for the poor primarily through the expenditure side of the budget. This chapter considers these principles and concludes that the ability to pay criterion is the most widely used.