Ability to Pay Principle

The ability principle is the most generally accepted principle. The ability to pay approach is
based on the broad assumption that those who possess income or wealth should contribute to
the support of public functions according to their relative abilities. The idea of a just and
equitable taxation—the distribution of tax burdens should be just—has been associated with
the earliest concept of ability to pay. According to this principle, every citizen should pay the
tax to meet the cost of government expenditure according to his ability to pay. If every citizen
pays the taxes according to his ability to pay, such a system of taxation would be an ideal
system. Ability is the ideal ethical basis of taxation. Ability commands universal allegiance
and fits in admirably with the modern conception of the state. According to Cohn, it is but a
special application of the broad principles of moral solidarity.

Justification of Ability to Pay Principle/Theory

Supporters of the ability to pay principle have justified it on three grounds: Firstly, it has been
justified on psychological effects of tax payments upon individual tax payers.
Psychologically, every tax payer should feel that he has made equal sacrifice in the payment
of a tax. Equality of sacrifice has been emphasised by Mill as what could be more equitable
than a situation under which each person's contribution to the support of government resulted
in equal sacrifice for all Secondly, the ability to pay principle is justified in terms of
diminishing marginal utility of income. As income increases, marginal utility of additional
unit of income decreases and vice versa. And, hence, for equality in sacrifice, the tax burden
should be made on the rich people than on the poor. Thirdly, the justification of ability to pay
is known as the faculty of interpretation. Faculty is the capacity of an individual to produce
and consume and this is represented by the income and the accumulated wealth of an
individual. After meeting certain basic needs, the individual is left with certain resources
which reflect a high degree of tax paying capacity.

How to Measure Ability to Pay ?

So far, economists have advanced two broad approaches for the measurement of ability to
pay. They are as follows :

(1) Objective Approach.

(2) Subjective Approach.
Measurement of Ability to Pay

Objective Subjective

Income Absolute Sacrifice

Expenditure
Equal Sacrifice
Price level
Marginal Sacrifice
Method of taxation
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Benefit
(1) Objective Approach. Some American economists have adopted objective approach for
the measurement of ability to pay. In the objective approach, the faculty theory has been
evolved to measure the ability to pay. The following are the bases or factors which determine
the ability of a person to pay taxes :

(i) Income—Income is by far the most important determinant of a person's ability to pay
taxes. Without income how can you pay taxes ? The greater the income he earns, naturally
greater is his ability to pay taxes. By income we meant the net income and not the gross
income of an individual. In income we can include the property in his possession which also
earns income. A person can pay a greater amount of taxes due to potential of earning he has
in the form of property. Similarly, the expectation of future income is one of the most
important determinants of a person's ability to pay taxes.

(ii) Expenditure-If a major part of income is spent in consumption, we cannot expect a

person to be in a position to pay taxes in proportion to amount of his income. Thus, two
persons with the same amount of income may not have the same ability to pay taxes on
account of the different number of dependents in the family and consumption habits. The
larger the family, the lesser will be the ability to pay taxes in comparison to one who has a
small family. Therefore, it is the net income after deducting the expenditure out of earned
income, which determines the ability to pay taxes.

(iii) Price Level—The price level also affects the ability of a person to pay taxes. The higher
the prices, the lower is the income of how the taxes can be paid and vice versa. Therefore, the
prices also affect the ability of a person to pay taxes.

(iv) Method of Taxation-If the taxes are so levied that they observe the canons of
convenience and certainty, the ability of a person to pay taxes would be greater. If the taxes
are levied at the time when he receives his income and, therefore, his ability to pay them,
would be greater, e.g., deduction of income tax at source.

(v) Benefits—Benefits accruing from the state expenditure also affect the person's ability to
pay taxes. This happens in two ways: Materially, if the state provides some services free of
cost or at concessional rates to its citizens, they would definitely save a part of their income
and thus enhance their ability to pay taxes. Psychologically also, the benefits which are
conferred upon the public give some psychic satisfaction to the public and they feel the least
sacrifice in paying tax. Their ability to pay taxes would thus increase both ways—materially
and psychologically.

(2) Subjective Approach—The subjective approach is based on psychological or mental

reactions of the tax payers. In the subjective approach, we estimate the burden felt by the tax
payer or the sacrifice undergone by him. Each tax payer should make equal sacrifice, if
burden of tax is to be justly distributed. Three main principles have been propounded in the
context of sacrifices to be made by the tax payer. They are as follows:

(i) Principle of Equal Absolute Sacrifice. (ii) Principle of Equal Proportional Sacrifice. (iii)
Principle of Equal Marginal Sacrifice.

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(i) Principle of Equal Absolute Sacrifice-According principle, the money burden of taxation
should be distributed amongst the various tax payers in such a way that every tax payer is
called upon to make an equal sacrifice. Thus equal absolute sacrifice would require that
person with higher income should pay more than those who have lower income in such a way
that sacrifice for each individual is the same, provided that the marginal utility schedule has a
declining trend. Since the marginal utility is high for a poor person than for a rich man, equal
sacrifice would mean that the poor should pay less amount of tax, the marginal utility of
which is high and the rich should pay more tax, the marginal utility of which is low, so that
the total sacrifice in terms of utility should be equal. It means that there should be single
uniform rate of taxation for all tax payers. However, the main difficulty with this principle is
that it is not at all easy to accurately estimate the sacrifice made by every tax payer.

(ii) Equal Proportionate Sacrifice-According to this principle, the burden of taxation on all
citizens should not be uniform, but it should be in proportion to the income earned by them.
Hence according to this principle, the taxation system instead of being proportional should be
progressive in nature.

(ii) Equal Marginal Sacrifice-According to this principle, taxes should be so imposed on

each individual that he makes an equal marginal sacrifice in terms of utility lost by
surrendering the marginal units of income. Since utility of marginal income lost as tax is
higher for the poor and lower for the rich, it is obvious that under the principle of equal
marginal sacrifice, the poor will pay less of income and the rich more such that there is equal
marginal sacrifice for both. Hence taxes should be distributed in accordance with the
principle of least aggregate sacrifice, i.e., the marginal sacrifice imposed by way of taxation
on each tax payer is equal. Prof. Pigou looks upon this principle as the ultimate principle of
taxation. However, if we apply this principle in actual practice, it may have the effect of
discouraging the savings of the community.