Ability-to-Pay Principle

Ability-to-Pay principle is principle of taxation which asserts that the amount of tax levied on an economic entity should be directly proportional to the ability of the entity to pay taxes. Therefore, a person having high income and wealth should be taxed more and less tax should be levied on those having low income and wealth provided other things remain constant.

Examples

Any taxes that result in higher tax being charged on high income or wealth, either proportionally i.e. same percentage on income and wealth or progressively i.e. low percentage on lower income/wealth and high percentage on higher income or wealth, are according to ability-to-pay principle. Examples include most personal and corporate income taxes and property taxes.

Arguments in Favor

Arguments in favor of ability-to-pay principle are:

  • The amount of money available to wealthier people far exceeds their basic necessities and since an average consumer acts rationally, wealthier people derive less and less additional satisfaction (marginal utility) from an additional Dollar spent. In other words, the value of a dollar for a wealthy person reduces as they spend more. The marginal utility per Dollar for a poor person also falls however, it is still much higher than that of a wealthier person. This means that if equal nominal taxes were charged, it will cause unfairly high utility sacrifice for a poor person than for a wealthier person. To equalize to the utility sacrifice caused by taxes, poor people should pay less and wealthier should pay more.
  • Progressive taxes, which follow ability-to-pay principle, can quickly fulfill the revenue needs of a government and also result in more revenue for government, provided there is no tax evasion.

Arguments Against

Arguments against the ability-to-pay principle are:

  • It is difficult if not impossible to determine the ability of a person to pay taxes. The term 'ability-to-pay' is ambiguous. It leads to questions such as: should the taxes be charged at a uniform percentage for all taxpayers or is it going to be a higher percentage on high income and low percentage on low income?
  • Taxes allow the government to offer public goods and services and the users of those goods and services should pay taxes according to extent to which they use public goods and services and not on the basis of how much they have earned.

Written by Irfanullah Jan