Decomposing the Redistributive Effect of Taxes: New Measures of Vertical Equity and Inequity

Two ethical norms, vertical equity and horizontal equity, are generally applied to assess the fairness and distributive justice of a tax system. Due to tax induced rerankings controversy surrounds the exact meaning and joint empirical application of the two equity concepts. This paper adopts Aronson and Lambert’s (1994) recently proposed measure of horizontal equity and demonstrates that overall or “net vertical equity” can be additively decomposed into three separate, distinct and quantifiable terms — “vertical equity”, “tax rerankings”, and “post-tax income rerankings”. The latter two terms involve vertical inequities that are embedded into an otherwise progressive tax system. To separate the two inequities from net vertical equity we make use of the relative deprivation interpretation of the Gini coefficient and decompose the redistributive effect of taxes into four distinct terms, three of which measure and decompose vertical equity and inequity. To illustrate the decomposition method we use individual income tax return data and measure the effects of the Tax Reform Act of 1986 on horizontal inequity, vertical equity, tax-rerankings, and post tax income rerankings. Horizontal inequity is measured using the recently developed procedure of Aronson and Lambert (1994). The remainder of the redistributive effect is decomposed using the new procedures developed in this paper.