What’s it: Ability to pay taxation is a taxation principle that says taxes should be per the taxpayer’s ability level. That is the main principle of implementing a progressive tax. Thus, people on higher or richer incomes should pay higher taxes than those on lower incomes.
Why is the ability to pay taxation important
Taxes are mandatory levies from taxpayers to the government. It is the primary source of government revenue, which can use it for various purposes, such as building infrastructure and paying government employees’ salaries. Also, taxes are a means for the government to distribute wealth and welfare through various programs such as free health and education, subsidies, and social benefits provision.
Ability to pay taxes is one of two principles of taxation. The other is the benefit principle.
Ability to pay taxation contains two equities in it, namely horizontal and vertical equities.
- Horizontal equity. People who earn the same income must be charged the same tax rate. So, if a retailer makes $100,000 and is subject to a 10% tax rate, then the automotive repair shop that makes $100,000 must also bear the same percentage, which is 10%.
- Vertical equity. Under this principle, those with different incomes should be subject to different taxes. Someone who makes $100,000 and someone else who makes $50,000 will have to pay different tax rates.
Difference between the ability to pay principle and the benefit principle
Under the benefit principle, those who receive tax or public service benefits must pay them proportionately. So those who receive higher benefits will have to pay more. Conversely, if the benefits they receive from government goods and services are low, they pay a lower tax rate.
Meanwhile, the principle of ability to pay states that taxpayers must pay taxes at different rates according to their wealth or income, regardless of the benefits received. Wealth can take real assets such as homes and financial assets such as savings accounts, stocks, and bonds. Meanwhile, income includes salaries, interest and dividends, and other payments.
Example of the ability to pay taxation
As I have already mentioned. The ability to pay principle is the basis of a progressive tax. Under this system, the tax rate increases with the wealth or income of the taxpayer.
For example, for income less than $10.000, taxpayers must pay a rate of 10%. Meanwhile, for income less than $50.000 but more than $10.000, the tariff is 15%. Meanwhile, for an income of more than $50.000 million, the tax rate is 30%.
The following is an example of a progressive tax for the 2020 federal income tax rate for a single taxpayer in the United States.
| Tax rate | Taxable income, in USD |
| 10% | 0-9,875 |
| 12% | 9,876-40,125 |
| 22% | 40,126-85,525 |
| 24% | 85,526-163,300 |
| 32% | 163,301-207,350 |
| 35% | 207,351-518,400 |
| 37% | 518,401 or more |
Pros and cons of the ability to pay principle
For supporters, the principle of ability to pay contains several benefits, such as:
- Maintain a minimum standard of living. This principle aims to stimulate the economy and ensure every citizen has a minimum standard of living. This system increases the ability of the poor to buy everyday goods because they pay less in taxes.
- Reducing the income or wealth gap. This principle’s application becomes a way to redistribute income from the upper class to the lower and middle class. People on higher incomes pay more to the government. Thus, this helps to keep the income gap from widening between the rich and the poor.
- Justifies social justice. Those who have low incomes should be helped by those who are more affluent. The rich should contribute more to the economy by paying higher taxes.
But, on the other hand, the application of the principle raises several criticisms, including:
- Discrimination. Despite paying higher taxes, the rich receive the same benefits as those who pay lower taxes. That is unfair.
- Relocation of wealth. A progressive tax system creates incentives to reduce taxable income. Those who are wealthier will tend to avoid paying higher taxes. They then divert wealth to low tax countries.
- Disincentive to become wealthier. Due to discrimination, taxpayers have less incentive to earn more money, especially if their income is close to the tax rate cap. Say, the tax rate for $10.000-$12.000 is 15%, and for income above $12.000 is 20%. When taxpayers have an income of around $11.500, they may be reluctant to earn a little over $12.000 because they will incur a higher percentage tax rate.
