Horizontal and Vertical Equity:

As a matter of logic, a tax system that assigned different tax burdens to people with different incomes should assign the same tax burden to people with same income. Viewed in this way, equal treatment of equals in taxation is not an end in itself, but rather a  means to ensuring that tax burdens are distributed in a way that is vertically equitable.  Benefit principle of taxation holds that tax  burden should be assigned according to the benefits that tax-payers receive from government goods and services. If one assumes that the benefits tax-payer receive from government spending vary with their income level, a case can be made that taxation  according to the benefit principle would require that tax-payers with the same income pay the same amount of tax. Under the benefit principle, vertical equity would require that tax-payers with different incomes pay different amount of tax.  But, depending on how benefits varied with income, vertical equity could require that benefit tax burden be distributed regressively, proportionately, or  progressively, depending on whether benefits from public goods and services rose less than proportionately, proportionately, or more than proportionately as income increased.

Under the ability-to-pay principle, people with the same incomes are considered to have the same ability to pay, and thus should pay the same amount in taxes.

Several conceptual issues should be kept in mind when applying the horizontal equity principle.  Which measure of income used to  group tax-payers as equals is important in this context.  The most commonly used yard-stick is annual income, comprehensively measured. Whether taxing income or consumption is consistent with horizontal equity depends on which definition of income one uses.

Consider, for example, the case of two people, Taxpayer A and Taxpayer B.  They live for only two periods of time.  In the first period both taxpayers work and earn Rs. 100,000, in the second, they retire and live from the proceeds of savings as accumulated in the first period.  Assume that taxpayer A saves Rs. 40,000 of income earned in the first period, and invest it at a return of 10 percent, while Tax payer B saves only Rs. 20,000, also invested at 10 per cent. To consider whether A and B, have equal incomes, measurement of income annually or over a taxpayer's lifetime is relevant. If annual income is used as the standard, then A and B would be seen to have the same income in period one (Rs. 100,000), but A would have a higher income in period two because of investment income Rs. 4,000 compared with only Rs. 2,000 of income for B.  Applying the principle of horizontal and vertical equity would require that A and B pay the same tax in period one, and that A pay more taxes than B in period two.  In this case, taxing  income meets the standard of horizontal equity, but taxing consumption would not. 

The reason is that in period one A would pay less in tax than would B, even though they have the same amount of income since A  consumes less than B in period one.  If life-time income is the standard of comparison, taxing based on consumption achieve  horizontal equity, while taxation of income imposes a heavier tax burden on people who have the same life-time income as others, but who prefer to shift more of their life-time consumption to latter years through saving. The standard of horizontal equity will have  limited applicability when taxes are levied on account for the presence of external costs.  For example, smokers and non-smokers will face different tax burdens even when their incomes are the same. Tobacco taxes are intended to force smokers to bear the external costs of smoking.