Ability to Pay Principle

Ability to Pay Principle

What is the Ability to Pay Principle?

Definition

The ability to pay principle is a method of taxation that seeks to tax those with greater incomes at higher rates. This form of progressive taxation is viewed as being fair and equitable as it imposes additional taxes on those who can afford to pay. Individuals who have lower incomes are thought to have a lower ability to pay tax and hence are taxed at a lower rate.

What does the ability to pay principle mean?

The ability to pay principle allows the government to increase its income tax revenues without placing an undue burden on individuals who earn lower amounts.

Consider a situation where an individual, A, earns $500,000 per year and B, another individual, makes $20,000 per year. If there is a flat rate of income tax of 10%, A will pay $50,000 as tax while B would pay $2,000 in taxes.

The amount left over after taxes with A would be $450,000, and B would have $18,000 post-tax. To many that seems unfair because B has a much lower ability to pay tax than A. The solution to this is a progressive tax where an individual earning a large sum would be taxed at a higher percentage.

In our example, A could be taxed at, say, 20%. This would still leave a post-tax sum of $400,000 ($500,000 – 20%), which is a substantial sum. Individual B could continue to pay tax at 10% or possibly be taxed at an even lower rate.

However, not everyone thinks that the ability to pay principle is fair. That’s because taxing rich persons at a high rate could work as a disincentive. Why should a person strive for a higher income if a significant portion is going to be taken away as a tax?

In the United States, individual income tax is based on the ability to pay principle. Let’s see how this works:

Example of ability to pay

Different categories of people pay tax at varying rates in the U.S.

The income tax rates applicable are 10%, 15%, 25%, 28%, 33%, and 35%. As the income level rises, the tax rate goes up. The top rate of 39.6% applies to single taxpayers whose income exceeds $426,700.

The ability to pay principle is applicable in the U.S. This ensures that individuals with limited incomes pay tax at a low rate.

Summary

The ability to pay principle imposes income tax rates based on a person’s financial standing. Those who earn less, pay tax a lower percentage of their income as tax.