Ability to pay principle is an idea that taxation should be based on the ability of the taxpayer. Lower-incomes individuals should pay less because they have a lesser ability to pay taxes. Conversely, wealthy or high-income should bear a high tax burden. This principle gave rise to a progressive tax system.
In a financial context, the ability to pay refers to the borrower’s capacity to repay interest and principal debt.
Ability to pay taxation
Two types of taxation principles, namely the ability to pay and benefits principles. The benefit principle states that the beneficiary must pay, and the tax burden must by the value of the service or benefits they receive. Meanwhile, the principle of ability to pay requires a higher tax burden on those who are more affluent and have a higher income.
An example of applying the benefits principle is the property tax. This type of charge is generally more stable over time than income tax because it depends on property values, not income.
Conversely, income tax varies depending on taxpayer income. So, it is more sensitive to the ability to pay taxpayers.
Progressive tax as implementation
Progressive taxation is vital in the concept of income redistribution. Low-income households are considered to need more government assistance, even though they contribute less. That way, their daily lives are helped.
On the other hand, despite paying higher taxes, more affluent people stay rich because they have accumulated wealth for some time before. Thus, higher taxes are considered not to burden them.
Of course, such concepts are criticized. While helping to redistribute income in the economy, Classical Economists see that progressive taxes can destroy initiatives to get better. Low-income households are increasingly dependent on government assistance (low taxes). Meanwhile, those who are wealthy are reluctant to develop entrepreneurship because of the high tax burden.
Pros and cons
Poor people cannot meet basic needs if taxes are high. They have a small disposable income. When they have to bear the same proportion of taxes with the rich, then the less money left to meet basic needs.
However, critics argue that it is difficult to measure the ability to pay from each taxpayer reliably. The application of the principle actually punishes those who work hard. Someone has a high income because they have worked harder. So higher taxes discourage people from earning more money and working hard.
Furthermore, tax authorities are vulnerable to manipulating the tax system. Tax rates vary according to income, making this system subjective and dependent on the personal opinions of tax officials.
Ability to repay bank loans
In banking, the ability to pay measures the chances of a borrower being able to pay off the principal and interest.
Banks will charge low-interest rates to borrowers with low default risk. They are considered to be able to pay interest and principal on time. Furthermore, banks will charge higher risk premiums when the risk of default is higher.
The bank uses many measures to assess the potential for borrower default. Relevant data that banks collect include disposable income (or discretionary income) and cash flow. In addition to the two, several variables are also added to the bank’s valuation, including historical loans, capital, capacity to generate cash, guarantees, and current economic conditions.