Ability to Pay Details

Governments who follow the ability to pay principle believe that imposing the same tax rate on all individuals and companies won't create an equal burden. To determine the proper tax rates, they have to consider other factors, including the ability to pay. To put it simply, entities who gain higher revenues should have higher tax rates than those with lower income. Those who advocate ability-to-pay argue that as a person's income increases, they will have less effective use of their money per given dollar.

In the real world, the ability to pay principle is the foundation of the progressive tax system. It's a taxation system requiring individuals with higher income to pay more tax. It's not a flat tax system where the government tax all individuals with the same income percentage level. Instead, it's a system where the higher your income, the more income percentage will be levied as a tax obligation.

The concept of the ability to pay is also relevant in banking. The principle in banking is more familiarly referred to as "capacity." Capacity is an indicator measuring a borrower's capability to repay their loan. It uses other indicators, including the debt-to-income ratio—the total amount of debts divided by gross income—to determine the borrower's ability to pay.

Real-World Example of Ability to Pay

The United States government uses the progressive taxation system, which adheres to the ability to pay principle. In 2020, US citizens with a taxable income of less than $9,875—excluding income not subject to tax—are imposed with a 10% income tax rate. On the other hand, the government levies those who earn more than $518,400 of taxable income per year with a 37% tax rate. Keep in mind that, in this case, taxpayers don't have to give away 37% of their total taxable income, though discussing how it works in detail requires a whole separate article. The tax rate varies depending on the income brackets, resulting in seven different rates: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

The US neighbor, Canada, also uses a similar system. In Canada, individuals don't have an obligation to pay income tax if their yearly personal revenue is less than $12,298. As income increases, putting you higher on the income ladder, only then will the government start to tax income incrementally. The tax rate is as follows: 0%, 15%, 20.5%, 26%, 29%, 33%. Canadian government imposes the 33% tax rate for individuals earning more than $273,334.

The principle of ability-to-pay works slightly different in banking. Banks use the debt-to-income ratio (DTI) as one of the main factors to decide whether to loan money to an applicant. Banks typically won't accept applications from potential borrowers with more than 35% DTI.

Significance of Ability to Pay

The application of the principle through the progressive tax system raises a handful of benefits. The main advantage is an equal tax burden. As mentioned earlier, people are not as dependent on money if they have higher earnings. The principle also allows wealthier individuals to join together, providing essential services to society in various fields, including transportation, schools, and medical research.

The ability to pay principle helps governments worldwide design a flexible taxation plan that scales well with revenue. If they choose to implement a flat tax system instead, the tax rate would need to be adjusted to be high enough for wealthy people but low enough for the less economically fortunate folks. In most cases, it's somewhat unrealistic.

Despite all these benefits, the ability to pay principle is not without weakness. The most prominent disadvantage is less motivation for individuals to get higher earnings. This can be a problem since the overall economy will benefit significantly if people are wealthier. Capitalists criticize the principle for being too restraining in a free market economy. That said, socialism and capitalism elements can work well together in most countries.