Measuring Increases In Horizontal Equity In The Absence Of Certain Itemized Deductions And Phase Outs

Abstract

A topic that generates extensive debate and concern is the perception of fairness in the US tax system.  This “fairness” is often defined as vertical equity – taxpayers with different amount of income pay different amounts of taxes, and horizontal equity – taxpayers with the similar income pay the same level of taxes.  Since the late 1980s, the number of phase outs in the United States individual income tax system has increased substantially.  The effect of these phase outs has, in some cases, increased certain societal-valued activities, while at the same time discouraged reduction in taxes to others who are viewed as upper-income.  On the other hand, some of these phase outs, and the ability to use them, may simply be a matter of luck or timing, or both.  When this is the case, the tax liability of two people with very similar incomes may become very different, thus decreasing horizontal equity.  This study begins by examining changes in horizontal equity (as measured by the coefficient of variation) when deleting two individual tax deductions.   Using the Internal Revenue Service Tax File database for roughly 60,000 married filing joint returns, we examined the sensitivity of equity measures to two “artificial” changes in the tax laws – the disallowance of the mortgage interest deduction and the charitable contribution deduction.  Not surprising, we find the disallowance of either or both deductions increases horizontal equity.  Additionally, in the absence of phase outs (using the 1989 IRS tax file), we prove that as income groups become more numerous (and hence narrow bands of income), horizontal equity increases as well.  This outcome is at odds with prior tax equity studies that make the assumption that increasing or decreasing the number of equal circumstance groups (taxpayers with similar income) will have no substantive effect on the outcome of horizontal equity measures.  It also shows that increasing phase outs, when only benefits some in even very narrow income groups, has the effect of decreasing horizontal equity.  This study has important implications in two respects.  First, from a methodological standpoint, prior studies should have strengthened their assumption on the number of equal income groups used. Second, from a public policy perspective, continuing to increase the number of phase outs within the tax system further distorts horizontal equity, thus undermining the fairness and equity perception of the tax system.