What is the Ability to Pay Principle?
Definition: Ability to Pay principle is one of the taxation theories that propose that taxes need to be paid according to how much one earns. This method of taxation seeks to tax those who earn high incomes higher rates compared to low-income earners.
Ability to pay taxes
It is a progressive taxation model considered as fair and most equitable since it imposes extra taxes on those with higher income and can afford to pay. According to the principle, those with lower incomes have a lower ability to pay taxes, and as a result, they pay taxes at a lower rate. In essence, what the principle implies is that one should pay tax according to the level of burden the tax creates compared to the income of the individual. The tax system thus has to factor in other issues besides the amount of tax one should pay.
Conventionally according to the principle, taxpayers are put into categories depending on how much they earn. Each tier has a different tax rate based on a predetermined amount of what individuals in that tier are earning and what they can afford to pay. However, the ability to pay is not similar to straight income brackets. Instead, it is a designation denoting whether one can pay its total tax burden or not.
For instance, individuals on low income usually get tax discounts, which mean that they don’t have to pay the entire percentage amount they are required to pay. On the other hand, those earning more will generally pay the whole percentage amount of taxes they owe.
Similarly, the principle holds that one should not pay tax on transactions that they don’t receive any cash, such as a stock option. Conventionally if one gets the securities, they should pay tax on them because they have value. However, since the individual does not receive cash from the options, he/she is not subject to taxation until the moment he/she cashes in the options.
Ability to pay principle in banking
The ability to pay principle in banking is referred to as “capacity.” Most lending institutions use it to determine the strength of the borrower to make principal repayments on loan as well as interest using his/her disposable income. Some institutions determine the strength of the borrower by using capital base, credit history, collateral, capacity to generate cash flow, and current economic conditions.
On the other hand, for issuers of municipal debt, the ability to pay principle is also different. It refers to the current and future capability of the lender or issuer to create enough tax revenue for them to meet their contractual commitments.
Why the ability to pay principle is important?
This progressive taxation model enables governments to increase their revenue from income tax without putting much burden on citizens earning low amounts. According to proponents, this taxation model is a significant form of income distribution. It is because low-income earners usually need government assistance more, although they generally contribute a significantly small proportion. The system allows the government to pull resources so that they can fund the much need services that most people require.
Criticism of this Principle
Although the principle is fundamental in resource distribution, some oppose it. There are arguments that it is tricky to establish someone’s ability to pay tax. Equally, what the government does is to impose a tax on income one earns and not the marginal utility of each individual.
Also, some feel that this system discourages economic success because it burdens those who earn more with disproportionate taxation. However, because of growing government budgetary needs, there are other solutions often considered more painful to taxpayers. According to classical economists such as Adam Smith, this progressive taxation is a form of socialism that is very dangerous and can destroy tenets of a free market economy.