Ability-To-Pay Taxation: a taxation convention suggesting that taxpayers should only pay tax amounts according to their individual ability to pay.
Ability-To-Pay Taxation Details
Many people believe that those with a higher income can afford to pay more in taxes. They feel they don’t have to worry as much compared to those with low incomes who struggle to pay for basic needs like food and shelter. This is one of the most basic arguments for ability-to-pay taxation (ATP), where governments impose higher tax rates on individuals who climb higher on the income ladder.
In other words, governments following an ATP system take larger portions of revenue from high-income taxpayers compared to low-income ones. Most countries in the world, including the US and European countries, use the ability-to-pay taxation system instead of a flat taxation system. This way, all individuals have the same tax rate regardless of income amount.
Taxation systems that follow the ability-to-pay principle are often referred to as progressive tax systems. With a progressive tax system, the government levies taxpayers with different tax rates depending on their income bracket.
One example is the progressive tax system in the US. In 2020, single citizens with a yearly taxable income lower than $9,875 get a 10% income tax rate, while those who earn more than $518,400 per year are faced with a tax rate of 37%.
To put it simply, two people who earn $9,000 and $600,000 respectively are taxed at two very different rates. That said, high-income taxpayers don’t necessarily pay the whole 37% of their income as tax, but we'll explain this with an example.
Example of Ability-To-Pay Taxation
Morgan is a single, unmarried US citizen who makes $612,400 per year. In that case, he belongs at the top of the tax’s income bracket and is imposed with the 37% tax rate. Since Morgan is single, he's eligible to receive the standard deduction of single taxpayers. Because of this, $12,400 of his income is not subject to tax, leaving $600,000 in taxable income. Let’s calculate the exact amount of money he needs to pay.
Imagine a set of stairs. Morgan’s taxable income is divided and put on each of the stairs’ steps. At the very bottom is his income’s first $9,875. Then $30,250 is on the second step, $45,400 is on the third step, $77,775 on the fourth, $44,050 on the fifth, $311,050 is sixth, and $81,600 is seventh. If you add up all of these numbers, the result is $600,000.
Now, each income amount on these steps is assigned its own tax rate:
- The $9,875 is taxed at 10% rate ($987.5)
- $30,250 at 12% rate ($3,630)
- $45,400 at 22% ($9,988)
- $77,775 at 24% ($18,666)
- $44,050 at 32% ($14,096)
- $311,050 at 35% ($108,867.5)
- $81,600 at 37% ($30,192)
In total, the amount of income tax Morgan needs to pay is $187,027. Or, the government imposes Morgan an effective tax rate of 31.17% ($187,027 divided by $600,000). It may seem high, but Morgan might be able to lower tax paid by utilizing other deductions instead of the standard one.
History of Ability-To-Pay Taxation
This taxation system, based on the ability-to-pay philosophy, can be traced back to Britain's modern era during the French Revolutionary War in 1799. At the time, Prime Minister William Pitt the Younger levied people with incomes over £60 to pay 2 old pence in tax, while those who make over £200 are imposed with a maximum of 2 shillings.
That said, Adam Smith, who is often referred to as the father of economics, popularized the idea in 1776. In his book titled The Wealth of Nations, he wrote, “The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.”
Significance of Ability-To-Pay Taxation
The principle of ability-to-pay also allows governments to design taxation systems that are more manageable to all, high income or not. In contrast, it's difficult for governments to implement a fair flat taxation system since people’s levels of burden can vary greatly depending on income. Having said that, there are still criticisms surrounding ability-to-pay taxation.
Some argue that the ability-to-pay taxation punishes those who work hard to be successful. The system may disincentive people to earn more money. Critics also believe that the system is not fair especially in a free market economy. They argue that paying more tax doesn't directly benefit high-income individuals.
People who advocate the ability-to-pay principle believe that those who are more economically resourceful are able and expected to contribute more to society. By assigning higher tax amounts to the riches, they believe society as a whole can have better infrastructure, education, and health care. In turn, this will promote economic growth and benefit high-income individuals in the long run.