A Cluster Analysis of Horizontal Tax Equity.

Abstract Horizontal inequity occurs in the federal income tax system when taxpayers with equal ability to pay taxes are not assessed equal taxes. This paper identifies and examines the horizontal inequities that arise from the differential tax treatment of different income sources. The study is based on taxpayer data from the 1988 individual Public Use Tax File. Cluster analysis is used to separate similarly situated taxpayers into groups with similar source-of-income profiles. Clusters at the same income level are shown to have distinct economic profiles. In a majority of income levels, different clusters have significantly different mean effective tax rates, supporting the proposition that source of income is a determinant of horizontal inequity. In particular, in most income ranges, a cluster with salary income as highest income source has the highest mean effective tax rate. An analysis of dispersion within clusters leads to observations as to which sources of income have higher uniformity of explicit taxation.