Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Vertical Equity

What it is:

Vertical equity is the concept of increasing tax rates on higher incomes. Vertical equity is similar to the concept of progressive taxes.

How it works (Example):

The United States has a vertical equity tax system, which means that different portions of a person’s or company’s income are taxed at increasing rates (that’s why the rates are often referred to as marginal rates). For example, the IRS might tax a single filer’s $100,000 income as follows:

The first $8,025 is taxed at 10% = $802.50
The next $24,525 is taxed at 15% = $3,678.75
The next $49,100 is taxed at 25% = $12,275.00
The next and final $18,350 is taxed at 28% = $5,138
Total tax owed: $21,894.25

Because this filer’s highest taxable rate is 28%, we say that he or she is in the 28% tax bracket. Note, however, that not ALL of the taxpayer’s income is taxed at 28%. In fact, the taxpayer’s actual total tax rate is $21,894.25/$100,000 = 21.89%.

The highest federal tax bracket changes often, but it is usually around 35% of any income over about $375,000 (note that this excludes state taxes and social security/Medicare, which can add as much as another 17%-18% in taxes, for a total of as much as 53% in taxes on additional income).

Why it Matters:

The idea behind vertical equity is that those who make more should pay more. In general discourse, however, it is important to know the difference between tax brackets and tax rates. Under a progressive tax system, many people assume that when they’re in the 28% tax bracket, for example, all of their income is being taxed at 28%, which is not the case.

As our example shows, you can be in the 28% tax bracket but actually have a 21.89% effective tax rate on your income. Likewise, executives and public figures are often chastised for having, say, a 15% effective tax rate, but as you now know, this does not mean that the person is not in a very high tax bracket.