Principles of Taxation

The Two Principles of Taxation Defined

It's not an easy task to define the two principles of taxation. There are several strongly accepted notions regarding what constitutes a fair allocation of tax loads among taxpayers. The two main ones are: the benefit principle and the ability-to-pay principle.

The benefit principle holds that there should be some equivalency between what an individual ends up paying and the advantages they get as a result of government actions. The ability-to-pay principle is the view that taxes should be levied dependent on a person's means to pay.

The Two Principles of Taxation: Compared and Contrasted

The primary distinction between the two principles is what is getting taxed. The benefits principle taxes the benefits that someone gets from a public product or service, whereas the ability-to-pay method charges you based on your earnings. They both are similar in the sense that they're both attempting to make tax as "fair" as possible. Unfortunately, both principles have their shortcomings and that's what makes them similar. In their attempt to be fair, they are ironically seen as unfair in their own ways.

The benefit principle is seen as unfair because taxpayers who have lower incomes may actually end up paying more in taxes than those with higher incomes. This affects them disproportionately and would actually negatively impact the economy. And the ability-to-pay principle is seen as unfair because in many circumstances, just because someone has more money would mean that they would have to pay more in taxes. This would result in people paying for things or services that they don't even use!

Ability-to-Pay Principle of Taxation

The ability-to-pay taxation principle states that people with greater earnings should give a higher percentage of their income in taxes than those with lower earnings. The principle behind ability-to-pay taxation is that everybody should make an equal contribution when it comes to paying taxes, and because individuals with more wealth have less need for a dollar, giving more in taxes doesn't really inflict a bigger strain.

This principle is founded on two considerations. One, we can't always quantify the benefits of government expenditure. Two, it presumes that individuals with greater incomes are less bothered by paying taxes than those with lower incomes.

The ability-to-pay concept should be used to establish taxes if the government's goal is to redistribute money. Nevertheless, measuring ability is challenging. Overall, there are three kinds of ways to measure ability to pay: salary, spending, and property.

Salary

Income is seen to be a greater predictor of ability than wealth. However, some obstacles are experienced here as well. Not all jobs require the same level of hardship. A man earning $1,000 via hard labor will not be able to pay taxes in the same way as someone making the same money by betting or winning the lottery, for example. Also, someone with the same salary as another could have a greater number of dependents and obligations, resulting in a decreased ability to pay.

Spending

A poor guy might spend more because he has extra dependents and must care for his elderly parents. As a result, his spending could be greater than that of his coworker in the same salary bracket. However, his spending does not represent his genuine ability to pay.

Property

Ownership of riches or real estate reflects well-being, but only to a limited extent. For instance, even if two people have the same amount of funds, they aren't identically wealthy. One could have some productive wealth, such as an apartment complex that brings in a steady flow of money. Another person may have unproductive riches (such as designer handbags) of equal worth. Obviously, their capacity to pay taxes will be vastly different. If taxes are based on the premise of the ability to pay, individuals with more of an ability to pay, as determined by salary and/or wealth, will pay more in taxes.

Benefit Principle of Taxation

The idea behind the benefit principle is to try to make tax obligations as fair as possible. Paying a toll, for instance, charges someone based on how frequently they travel over a specific road or highway. A high level of usage for that road or highway results in a higher amount of money you end up paying. After all, every time you need to use that road you end up paying the toll. In the end, you spend more than someone who only uses that road or highway once in a blue moon.

However, there are people who don't see the benefit principle as being the fairest. But for what reason? It turns out that determining how much an individual benefits from a service can be close to impossible. Let's run through an example to see how this is true:

Determining the answers to these questions isn't straightforward and can become messy rather quickly. That's why some governments choose not to use the benefits principle and instead choose to use a different tax structure that would allow for at least a partial redistribution of wealth. Lower-income taxpayers might have a greater shot at bettering their financial status under that type of structure since less of their earnings would go toward taxes. This sort of approach also serves individuals who cannot afford to pay.

Examples of Two Principles of Taxation

Let's go through some examples of the two principles of taxation in turn: the ability-to-pay principle and the benefits principle.

Ability-to-Pay Principle of Taxation

An example of the ability-to-pay principle would be the income tax brackets. Tax rate increases are linked to the increasing incomes of people within their own tax brackets. Let's go through what that looks like.

Benefits Principle of Taxation

An example of the benefits principle would be transportation system taxes.

Rich people would be significantly less burdened by paying the same amount in taxes since they would still have enough money to support their lifestyle, put money away for emergencies, and make investments.