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A Brief Introduction to the Principle of Tax Equity

By George L. Salis

13 August, 2007

The Concept Defined

Quite often we read law or tax material and we encounter the phrase "tax equity."  As we read the complex revenue decisions and court rulings, we began to discern the ideal and definition of tax equity, and perhaps, we may even be able to penetrate its meaning to some extent.  However, what exactly is tax equity?  When one suddenly reads of this elusive concept, it almost appears as a contradiction in terms, an oxymoron.  Is it possible for taxes and/or taxation to be "equitable?" 

In order to understand the principle of tax equity, a concept that at first encounter, confounds both lawyer and accountants alike, we must first look towards the principles of equity jurisprudence and define equity.  Thereafter, once equity is understood as a matter of principle, we can begin to see how equity is defined when applicable to taxation.  Although this may sound simple enough, this is not an easy task.  Even for experienced members of the bar and bench, a mechanical or basic understanding of equity, or its application, is not sufficient to render a precise interpretation of the concept behind the principle of tax equity.  In this case at least, equity is more a matter of economic analysis of law, and less of legal substance and fairness. 

Comprehension of the principles of equity, are also vital in the understanding of other collateral areas of law, such as contracts, trusts and estates, future interests, as well as the law of succession, etc.  A brief review of the history of equity may provide a valuable introduction to non-lawyers, offshore investors, and other professionals whose legal traditions that may be foreign to the predominant English legal perspective of Equity.  It may be also provide a review to others, which may further serve as a basis for understanding the principles of equity, fairness, and justice (whether legal, social, or economic in nature), and as legislators, courts, and legal scholars endeavour to apply in reality. Equity is important also in the Civil Law tradition of the Continental European countries, which are primarily based upon Roman law.  This is still discernible in their Commercial Codes, their laws of succession (known as Patrimony), and the similar, but distant relative of the English trust, called the fideicomissum, as well as other remedies and relief. 

The informed offshore investor, especially those living in non-Common law nations, will welcome this brief overview of equity, as it presents a valuable opportunity in the understanding tax equity as defined by courts, and supranational organisations such as the Organisation for Economic Co-operation and Development (OECD).  The OECD has thus become the leading promoter of global tax co-operation, a well as tax and regional economic symmetry. 

Equity is often defined as (fundamental) fairness, the application of the ideal of justice, good faith, and "good conscience[1]."  Nevertheless, to define "justice" is easier than to apply it.  As to "do" justice is very difficult, as what represents justice for some, may not be so for others.  Thus, this become much more complicated in the application of "economic" equity, or the kind of equity that is distributive of economic resources, such as income, capital or pecuniary self-interest.  Most people believe that they have a primary right to keep their earnings, since they have worked hard to acquire it.  Few people like to be taxed a little, let alone a lot.  Hence, what constitutes tax equity, or fair taxation?  What amount constitutes a "fair share?"  If one asks around, and surveys scores of taxpayers anywhere, it is very likely that the answer will vary depending on the socio-economic condition of the taxpayer.  But, it is almost certain that governments and taxpayers will disagree in the amount and quantity of tax rates, exemptions, exclusions, credits, allowances, and the (so-called) tax break.  In other words, what is fair for tax collector, is certainly not the same for taxpayer.  How can then equity or fairness, as a standard in taxation, be defined and given exact application?  This, of course, is the difficult dilemma that occupies law- makers everywhere. 

It is a dilemma for governments because an excessive tax regime can curtail, and even diminish economic and social growth and prosperity.  People often become discouraged as to the loss of their accessible income in payment to the government, and as a result, it becomes counter-productive.   It is similar to the diminishing return curve in the macro-economic scheme of any nation.  The answer may lie in the meaning and significance of equity as a system of jurisprudence; designed to meet the mechanical application of the law and law courts in earlier times.  It allowed for flexible remedies and adjustments in the application of legal principles based upon unusual facts and extraordinary circumstances.  It is also based on the authority and jurisdiction of the sovereign (government) that is compelling its prerogative upon the citizen, with its exclusive idea of "fairness and justice." 

II.        The Origin of Equity

The term equity derives from the Latin "æquitas."  As mentioned before, it stands for justice, equality, and fairness.  Although equity has always existed in one form or another in various advanced civilisations, it was first noticed in the West in ancient Hellenic Greece, and much later adopted by the Romans during their occupation of Greece[2].  It was when it entered Roman jurisprudence, and the great body of Roman Law (Corpus Juris Civilis), that "æquitas," or equity began its development into a body of laws, beyond the few axioms and rules of the Greeks. The Græco-Roman ideal of equity represented flexibility and common fairness; it was justice emanating from morality, natural right, and reason in law.[3] It exemplified the virtues of conscience and reason in a rigid system of legal rules.  Consequently, equity evolved into the principle of clemency, mercy, and fairness, frequently invoked (even today) in courts, in order to prevent miscarriage of justice or "inequities" imbedded in strict legal doctrines, and to mitigate the hardships created by these rules.  The reader must bear in mind that this is but a concise account of the vast and complicated history, which today constitute equity jurisprudence. 

When William "The Conqueror" Duke of Normandy invaded England in 1066 A.D., he took equity to England as part of the system of law administered by the Church in those days, which had preserved the Roman Law notion of equity.  Thus, equity as an extraordinary application of discretion, based on clemency, fairness, and the ideal of justice, first appeared when it became a method used by English judges during the early and formative years of the common law.  It was during the 14th and 15th centuries that the common law courts flexibly adapted their rules, remedies, and procedures to the growing needs of their culture, and litigants often invoked the ancient concept of equity, or fairness and reason to warrant adaptations and changes in law and legal rules.  This practice within the common law courts, eventually declined, and subsequently stimulated the creation of a special court of equity, called a "Chancery" court, which administered a system of procedures and special remedies based upon "equity."[4]  This was in contrast to the system of legal rules, remedies and procedures of the common law courts.  These were called (and still are) chancery courts, because the Chancellor was the most significant minister of the Crown, second only to the King or Queen.  The Chancellor often governed with, or on behalf of the Monarch, in the everyday machinery of government including the law courts.  Still today, the Lord Chancellor is perhaps, Britain's most powerful minister, next to the Prime Minister and the Monarch.  He is in charge of the Judicial policy of the nation, heads the Judiciary, is a legislative member of the House of Lords, the Prime Minister's Cabinet, and heads the Judicial Committee of the House of Lords, which is the UK's (and the Commonwealth's The Privy Council) highest Court. 

Eventually a dual system of national courts developed in England, and Chancery court became the court to hear the certain grievances and petitions which the common law courts could not (or would not) handle adequately.  The Chancellor's jurisdiction was said to be a "matter of conscience," as he was not bound by the mechanical and rigid rules of the common law.  Rather, he dispensed remedies according to equity that is according to the principles of fairness and justice, when the (common) law failed in this regard.  Like today, equity and Chancery applied only in certain cases where the legal remedy was inadequate or in extraordinary circumstances to prevent a great harm or injustice.  Thus, equity became, and still is, an auxiliary and supplementary system of justice, and in many ways, considered superior to the law and its strict interpretation.[5]  Equity, and it principles, arrived with English common law to all the colonies such as America, Canada, India, Australia, New Zealand, most of the Caribbean, etc, and there it remained.  However, the dual system of courts eventually disappeared as law and equity were merged into a single administration by the law courts, although still considered and applied separate in many jurisdictions of the common law world including the US, Canada, and other countries. 

III.             The application of "Equity" to Taxation and Revenue Law 

In the field of taxation, the principles of equity apply less as a matter of law, and more as a matter of social and economic equity.  Here, the principles of justice and fairness become much more important to the government as a matter of integrity, as the "fairness" principle applies to a form of equal and distributive justice, as the government's quest is for every taxpayer to pay his/her "fair share."  But, what is a "fair share" and how is it determined?  To answer this question, one has to look into the objectives of taxation as a whole.  Tax equity is founded upon the ideal that all productive members of society should contribute to its preservation, and consequently, all its members should pay their fair share through taxation.

For governments, taxation is much more that just a means to raising revenue or funds.  Largely through taxation, governments attempt to achieve various economic and social objectives.  These objectives expand through the entire gamut of society from local goals through international social, political, and economic objectives.  Thus, taxation becomes a complex, but intricate component to a much larger design in a nation's overall macro-economic architecture.  These objectives include shifting wealth from the rich to the poor (this is known as distributive equity or justice), maintaining price stability, stimulating economic growth, efficient foreign exchange and trade balance, national security goals, and revitalising (full) employment.  

Legislators almost everywhere, in the effort to meet the objectives above, enact tax rules aimed at eradicating and/or mitigating undesired economic and social conditions which may already exist, and to bring equilibrium, or at least a sense of balance to the complex economic landscape of a country.  They also enact tax rules that may promote or provide incentives for various economically advantageous activities.  However, through the years, the concept of tax equity has been shaped by two prevailing standards: the benefit principle and the ability-to-pay principle[6].

 The benefit principle, although less germane in our purpose here, is also based upon the equitable measures of economic distribution.  It is based on the rule that all tax burdens are to be distributed in the same proportions as the benefits derived from government.  As this is not the basic principle underlying US federal taxation, or the national tax system of most developed nations, including those nations comprising the OECD, I will omit further discussion of it here, as it is outside of our immediate scope.

The main standard of fairness, or equity most applicable today around the world, by most tax authorities, is the latter, the ability-to-pay principle.  This (pure capitalist) prime axiom of taxation has been the chief criterion of taxation since 1776, when Adam Smith, the father of modern economic theory, first expounded in his all-time economic classic The Wealth of Nations.  This principle is based upon the simple notion that the "...highest taxes should be levied on those with the highest ability to pay."  Aside from its capitalist origin, it took well with the Utilitarians, and was advanced further by the likes of social reformers as Jeremy Bentham and J.S. Mills.  This concept of tax equity is largely based upon the economic success of the individual taxpayer, as it correlates the ability to pay, with the consequent tax obligation.

The ability to pay principle has two measurable scopes; a) horizontal equity, and b) vertical equity.  Of the two, the latter is more in line with the capitalist school.  That is, vertical equity requires that those who have more, can afford more, so they should pay more.  Horizontal equity on the other hand, is more in line with Utilitarian principles, and it holds that economically situated taxpayers occupying similar positions should pay equal taxes, thus a balance of social and economic interest.[7]  Therefore, the principle of tax equity can be said to be proportional in nature, whether vertical or horizontal.  Theoretically speaking, the concept of tax equity is legal in nature, but in practice, the application in taxation is entirely economic.  The following simple equation, which I have contrived for some of my economic and tax courses, depicts this interesting notion:

N/Teq = ∑p (Heq  + Veq)

       ∆

Which means that in order to "fairly" balance revenue collections, a Nation's (N) tax equity equals the sum (∑) of all taxable contributions (p -for payments) made in a country, whether horizontally or vertically by all its taxpayers.  Here, T equals tax, depicted by the Greek letter tau.  To simplify, eq, stands for equity, and of course, H and V means horizontal and vertical.  The Greek symbol Delta (∆) depicts changes in the contribution curve, meaning that at times, either H or V, may rise up or fall, and hence, we see changes in policy and enforcement of taxes, that may move accordingly.  This may be demonstrated by the fact that during the past few years of economic growth and prosperity, the Internal Revenue Service (IRS) was under siege by the people and the US Congress, for their reckless, negligent, or intrusive and abusive practices. In the past years, many hearings were held in the American Congress, in this regard by various special congressional committees.  However, earlier this year, as the economy started to turn sluggish, and recession was on the horizon, (no pun intended).  Some members of the Congress already signalled that hearings would be conducted this year concerning the "stricter" enforcement of offshore tax avoidance, and to enquire as to why the IRS was not doing more to "crack-down" on the illegal use of offshore enterprises to avoid taxes.  They are also gesturing that further changes in the laws may be coming, should the problem not be corrected at a sensible pace. A good legal case where concept of tax equity was explored and explained effectively in this particular context was: Knetsch, Et Ux. v US[8].  Here, the court looks into insurance payments deductions, and the definition of economic value for tax purposes. 

IV.       Conclusion 

Most tax systems in existence in the world today are primarily based upon the ability-to-pay principle of tax equity, although one may find some elements of the benefit principle still embedded in most tax systems as well.  Nevertheless, many economists and legal scholars feel that although grounded upon equity in theory, this type of tax regime is not really equitable, in that it penalises the economically "successful" taxpayer.  They feel that it is he or she that bears the major burden in a tax systems where contribution does not equal to distribution.  They also further this argument by stating that those taxpayers with greater wealth also support the economy through investments, expensive consumer habits, etc., which keep people employed and the economy in sound balanced condition.  Therefore, the question in defining tax equity becomes not whether everyone should contribute in the payment of taxes, but whether some are contributing much more than others?  Consequently, some may argue that this is "unfair" contribution, and hence, it cannot be equity. 

It is noteworthy that although the meaning of tax equity is determined by the legislatures, and not by the courts, the public appears to be overwhelmingly in favour of it.  Surprisingly, the vast amount of revenue collected in the world's major economies, is in essentially voluntary, as it is also the self-assessment procedure prior to filing each year.  This can only be possible because the public, by and large, perceives the tax system to be fair and equitable, for the most part.  Equity is perhaps the most important quality in an efficient tax administration, and it is considered by most to be the primary characteristic of a beneficial tax system. 

[1] Halliwell, Margaret, 1997, Equity & Good Conscience in Contemporary Context, pg. 1-3 Old Bailey Press, London,.

[2] Cohen, Morris. 1961. Pg. 63-64, Reason and Law. New York Collier Books.

[3] Buckland, W,W. [1911] 1983. Equity in Roman Law: Lectures Delivered in The University of London at the Request of the Faculty of Laws, Littleton, CO, USA: Rothman Publishing.

[4] Berman, Harold, J. and William R. Greiner. 1980. The Nature and The Functions of Law, 4ed.,  Pgs 73-75,

Mineola, NY. Foundation Press.

[5] Id., at pg. 74.

[6] Rice, Steven, J. 1996. Introduction to Taxation, pgs. 15-17.South-Western Publishing. Cincinnati, Ohio.

[7] NOTE: for a more in-depht and excellent analysis on the legal concept of tax equity in case law and legislation, refer to Karl S. Coplan, Protecting the Public FISC: Fighting Accrual Abuse with Section 446 Discretion.  1983. Columbia Law Review, 83 Colum. L. Rev. 378. Also, John A. Papahronis, Taxation of Americans Abroad Under the ERTA (1981):An Unnecessary Windfall. 1982. Northwestern School of Law, Journal of International Law & Business, 4 J. INTL. L. BUS. 586.

[8] U.S. 1980, 5 L.Ed. 2d 128 (1960).

About the Authors

LLB (Hons), MA, LLM (cand.), PhD
Adjunct Professor of Economics, Rollins College, Florida, USA.