Ability to Pay Principle

What is the Ability to Pay Principle?

Definition: Ability to pay principle is the concept that individuals shouldn’t be required to pay taxes beyond their wherewithal to pay the taxes. In other words, it’s a concept that determines the proportional amount of tax levied on an individual based on his or her income and capability affording the taxes.

Ability to pay is an economic principle that states that the amount of tax an individual pays should be dependent on the level of burden the tax will create relative to the wealth of the individual. The ability to pay principle suggests that the real amount of tax paid is not the only factor that has to be considered, and that other issues such as ability to pay should also be factored into a tax system.

Ability to pay is economics concept that those who have more resources (wealth), or earn higher incomes, should pay more taxes. The ability to pay taxes (such as income tax or tax on luxury goods) are used as means of income redistribution. Also called ability to pay tax.

The Ability-to-Pay Theory of Taxation

The ability-to-pay theory is one of the main theories of taxation. According to the theory, taxes should be based upon the amount of money people earn. For example, those who earn more money are expected to pay a higher rate of taxes (which means a higher portion of their income) than people who earn less money. Remember, governments impose taxes to pay for services, like public schools, roads, police, and governance.

The ability-to-pay theory of taxation does not take into consideration the amount of these services that taxpayers actually use. For instance, all taxpayers contribute to public schools, even if they do not have any kids in a school system.

What Does Ability to Pay Principle Mean?

What is the definition of the ability to pay principle? This principle seeks to impose a higher tax on people with a higher income and a lower tax on people with a lower income, ceteris paribus. This way lower income people aren’t taxed excessive amounts relative to their overall income.

This is the fundamental principle in the progressive tax system of the United States, which seeks income redistribution. The amount of money spent by wealthy consumers is higher than their basic necessities. Conversely, the amount of money spent by lower-income consumers is lower than their basic necessities. With this concept, the lower-income people can meet their tax obligations because they are lower than those of the higher-income people.

This concept also extends beyond simple tax brackets and income levels. For instance, individuals shouldn’t be taxed on transactions in which they don’t receive any cash. An example of this is stock options. An employee who is granted stock options receives something of value that is subject to taxation, but because they didn’t receive any cash, they can delay the tax on the options until they cash them in.

In banking, ability to pay is called “capacity.” It is used by lending institutions to determine a borrower’s ability to make his interest and principal repayments on a loan, using his or her disposable income or cash flow. Some bankers judge a borrower’s capacity using the standard Five C’s of Credit – credit history, capital base, capacity to generate cash flow, collateral, and current conditions in the economy. For municipal debt issuers, ability to pay refers to the issuer’s or lender’s present and future ability to create sufficient tax revenue to fulfill its contractual obligations.

Example

Michael works as a bass-boy at a fine dining restaurant and earns an annual income of $36,800. Brandon is a chief financial analyst with an annual income of $225,000. The government seeks to raise the tax rates in order to collect more money towards lowering government debt. On the other hand, the progressive tax system requires higher tax rates on people like Brandon and lower tax rates on people like Michael.

Michael and Brandon belong to different tax brackets. Michael belongs to 15% tax bracket for an income between $37,650 and $91,150, and Brandon belongs to 33% tax bracket for an income between $190,150 and $413,350. With the introduction of the ability to pay principle, Brandon, who earns more than $75,000 annually, will pay 100% of the taxes, which is $225,000 x 33% = $74,250. Michael, who earns less than $75,000 annually, will pay 25% of the tax, which is $36,800 x 15% = $5,520 x 25% = $1,380.

Although the ability to pay principle makes sense, there are arguments against, mainly because it is difficult to accurately determine a person’s ability to pay taxes. Furthermore, the government imposes a tax on the income earned, not on the marginal utility of each consumer.

Different categories of people pay tax at varying rates in the U.S.

The income tax rates applicable are 10%, 15%, 25%, 28%, 33%, and 35%. As the income level rises, the tax rate goes up. The top rate of 39.6% applies to single taxpayers whose income exceeds $426,700.

The ability to pay principle is applicable in the U.S. This ensures that individuals with limited incomes pay tax at a low rate.

Summary Definition

Define Ability to Pay Principle: The ability to pay principle imposes income tax rates based on a person’s financial standing. Those who earn less, pay tax a lower percentage of their income as tax.

Ability to Pay Principle depends on the following significant variables:

  • The capability of producing revenue in current and future time with an outlook for the clearance of principal amount along with interest. We can also call it the economic solvency. The money and this income’s stability both.
  • Present assets and revenue available to the lender.
  • Other guarantee cases or 3rd party guarantees and the existence of substitute sources of payment as well.