Ability to Pay and Benefits Received Principle of Taxation

7 months ago

Atiqur Rahman

10 minutes

Ability to Pay Approach of Taxation:

The ability-to-pay principle, states that the taxes should be levied on the basis of the ability to pay of an individual. In other words those having higher income must be levied with higher taxes as their ability to pay is more, while the lower income level individuals must be levied with lower taxes as their capacity to pay is less.

Taxes are a means of shifting the purchasing power of income to governments; and hence the ability to pay is based on income. Those who have higher income can afford to pay more tax, that is, they have a greater ability to pay.

The ability to pay has two major criteria’s:

1. Horizontal Equity: The horizontal equity principle states that people earning the same irrespective of their position or status must pay the same. For example Mr. A junior executive of X company is paying tax 5000 (i.e. 10% on his salary of say 50000) then the clerk of some other company who is also earning the same 50000 bugs must pay 5000 bugs as tax, as his ability to pay is the same even though his position in a bit lower in the company.

2. Vertical Equity: Vertical equity states that the payment of taxes should be dependent on the level of income earned that is the ability to pay. In other words different people with different ability to pay must pay differently. For example Mr. A earns 50000 bucks and pays 5000 @ 10% on his salary as tax, than Mr. B who is earning 5000 bucks must pay 500 bucks as tax @ same 10% on his salary.

Approaches to the Measurement of Ability to Pay Principle of Taxation:

1. Subjective Approach:

Subjective approach to tax paying ability states “sacrifice” as the decisive factor for determining the tax burden. Every time a tax is levied on an individual, he feels a pinch or suffers from a disutility. That pinch or degree of disutility is the amount of sacrifice by the individual and he must be made responsible for the same. Therefore under subjective approach the tax burden is defined by the amount of sacrifice made by the tax payers.

Here three principles of sacrifice have been given, which are later explained in detail for reference.

The principle of Equal Absolute Sacrifice
The principle of Equal Proportional Sacrifice
The principal of Equal Marginal Sacrifice (Minimum Aggregate Sacrifice)

(i) The Principle of Equal Absolute Sacrifice:

The principle of equal absolute sacrifices states that the tax levied with regards to the utility scarified must be same for all tax payers. The principle of equal absolute sacrifice requires:

U(Y) – U(Y-T)

Should be the same for every individual

Where,

U stands for total utility

Y states the Income

T states the amount of tax.

U(Y) states the total utility at a stated income Y

U(Y-T) states the total utility of post tax income.

(ii) The Principle of Equal Proportionate Sacrifice:

The principle of equal proportionate sacrifice states that every individual should be levied with that amount of tax that the sacrifice of utility as a proportion of his income is the same for all tax payers. The principle of equal proportionate sacrifice requires:

U(Y) – U(Y-T)/U(Y)

Should be same for all tax payers. That is to say an individual with higher income is levied with same proportion of sacrifice, even with the given falling marginal utility of income, he is required to pay tax at higher rate. Therefore it is also known as progressive income tax.

(iii) The Principle of Equal Marginal Sacrifice:

The principle of equal marginal sacrifice states the tax burden must be levied in such a manner that the marginal sacrifice of utility of each and every person paying the tax could be the same. This way the aggregate sacrifice of the society as a whole can be minimized.

If we try to elaborate this, we can see if all person pay that much tax that their marginal sacrifice of utility is the same, the loss of total utility by the society will be the minimum. Hence this approach looks at the problem of distributing the tax burden efficiently for the better results in the society as a whole. As per its nature when the marginal utility of income falls, this principle of equality of marginal sacrifice implies high rates of taxation. Hence this principle recommends a high progressive tax structure.

Edgeworth, Pigou and Musgrave propounded this principle of taxation and considered as the ultimate principle of taxation. ”The minimum sacrifice is the sole objective of this principle”.

Critics of Subjective Approach:

The principle is completely dependent on the assumption the ability to pay is entirely dependent on the sacrifice of utility, which cannot be measured in a cardinal sense.
There is no definite evidence to prove that the marginal utility of money has an inverse relationship with the total income.
Interpersonal comparison of utility is considered as unscientific, which the basic criterion to prove this approach is.
The measure of utility income cannot always be measured exactly with the cardinal approach.

2. Objective Approach:

The objective approach to the ability to pay principle focuses on the objective base of taxation which measures ability to pay accurately. Unlike subjective approach income is not taken as a base here because an individual’s income determines his command over resources but it is a proven fact that the ability to pay does not increase in direct proportion to money income. Ability to pay increases more than proportionately to the amount of income.

To ensure equity in taxing income distinction should be clearly made between earned and unearned income and also number of dependents on the tax payer must also be taken into consideration.

Another objective measure of ability to pay is Wealth of an individual, which is also taken as a tax base. Savings from several previous years add up to an individual’s wealth which in turn determines how much resources a person holds. Therefore wealth is considered a better index to compute the taxable capacity of an individual. More specifically wealth and income together should be taken for the same for better measure from the viewpoint of ability to pay.

Prof. Kaldor states wealth and income to be an incomplete barometer for the same and instead proposed Total disposable income or assets as a barometer to know the paying capacity of an individual. He also focused on another parameter that is consumption that is income minus savings.

According to him total income is not consumed by an individual , a part of it is consumed which is taken out from the economic cycle for personal use while on the other hand the savings are reinvested in the economy as capital stock in the economy and therefore remains in the economic cycle. In other words it is the expenditure tax both in developed and developing economies which should be considered as the true barometer to compute the tax payable capacity of an individual.

Benefits Received Approach of Taxation:

The alternative approach to ability to pay is benefit received approach, which states that the taxes should be based on the benefit received rather than the income received as those who receive higher benefits must pay accordingly. Example commuters must pay for roads, 4library patrons must pay for libraries, students must pay for education, etc.

Critics of Benefit Received Approach:

The limitation of this approach is, that it is difficult in its application. The true benefit received by an individual from the government is almost impossible to calculate. For example, the tax paid for the education of a kid to the government, the benefit cannot be computed in an objective sense completely.
Majorly, the government expenditure is incurred on common invisible benefits which cannot be divided or apportioned evenly between the individuals.
It is against the general objective of tax, which is not to pay against a specific service but as a payment for the general purpose to the state.
It will indicate only how much tax revenue should be paid to the government, but this will not help us in dividing the tax liability amongst the individuals.
This principle can be easily applicable only in cases where beneficiaries can be clearly identified.

To summarize, benefit received approach can be used only to get the partial solution to the problem in fair and equitable distribution of tax liability.

Ability to Pay and Benefits Received Principle of Taxation

Ability to Pay Approach of Taxation:

Approaches to the Measurement of Ability to Pay Principle of Taxation:

1. Subjective Approach:

(i) The Principle of Equal Absolute Sacrifice:

(ii) The Principle of Equal Proportionate Sacrifice:

(iii) The Principle of Equal Marginal Sacrifice:

Critics of Subjective Approach:

2. Objective Approach:

Benefits Received Approach of Taxation:

Critics of Benefit Received Approach:

Read More in: Theory of Public Finance

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Ability to Pay Approach of Taxation:

Approaches to the Measurement of Ability to Pay Principle of Taxation:

1. Subjective Approach:

(i) The Principle of Equal Absolute Sacrifice:

(ii) ​The Principle of Equal Proportionate Sacrifice:

(iii) ​The Principle of Equal Marginal Sacrifice:

Critics of Subjective Approach:

2. Objective Approach:

Benefits Received Approach of Taxation:

Critics of Benefit Received Approach:

Read More in: Theory of Public Finance

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(ii) The Principle of Equal Proportionate Sacrifice:

(iii) The Principle of Equal Marginal Sacrifice: