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Ability-to-Pay Principle of Taxation

Dr. Ikramul Haq[i]

It states that if a given amount of revenue is needed to finance public services, then each taxpayer should contribute in line with his ability-to-pay taxes. Those who possess more economic power (income and wealth) should contribute more to public exchequer and vice versa. The duty to pay taxes is seen as a collective responsibility rather than a personal one. The ability-to-pay principle views tax policy issues in isolation to incidence of public expenditure. This principle is regarded by many as the most equitable and just method of taxation. It is emphasized primarily for its redistributive role.

For implementing the ability-to-pay rule, it is necessary to know as to how this ability is to be measured. Should ability-to-pay of an individual be identified with his income, net wealth, family size, health status of family members or some combination of these and other factors? And if a combination is to be considered, how to decide the relative weightage to be assigned to each of the various factors? Formidable problems arise when two individuals with equal incomes but unequal wealth or equal wealth but unequal incomes are considered. More serious problems arise when individuals A and B have unequal incomes and unequal wealth in such a way that A has more income than B and B has more wealth than A. How is the inequality of income to be adjusted against the inequality of property? In short, the question I show should people with differing abilities be treated for the purpose of taxation? Unfortunately, such questions cannot be answered objectively.

Though not perfect, the index of taxable capacity is commonly interpreted in terms of a taxpayer’s income with his wealth acting as a supplementary factor.

Granted that ability-t-pay is to be measured in terms of income, it is simple that taxpayers with equal incomes should pay the same amount of tax. This is called horizontal equity, i.e. taxpayers in similar economic circumstances should bear the same tax burden, economic circumstances being defined in terms of level of income. The second aspect of ability-t-pay rule is vertical equity, i.e. taxpayers in dissimilar economic circumstances should bear dissimilar tax burdens. Thus, persons earning more should pay more tax than those, earning less. Obviously, formidable problems arise when taxpayers with different income levels are considered and decisions are required as to how the tax system should deal with these differences. In other words, how far the taxes on people with different incomes should differ to ensure vertical equity?

Both the aspects of ability-t-pay rule are based on the philosophy that tax burden on individuals should be so distributed as to force them to make ‘ equal sacrifice’, being defined as loss of utility or satisfaction by surrendering units of money as tax.

The equal sacrifice rule, associated with such distinguished economists as J.S. Mill and A.C. Pigou, is based on the following assumptions. 1. It is possible to relate units of income with units of utility. 2. The utility curve for income has a downward slope, i.e. marginal utility of income varies inversely with income. 3. The marginal utility of income curve is the same for all individuals.

Under these assumptions, the equal sacrifice rule is clear for taxpayers with equal incomes. They should surrender equal amounts as tax which in turn means sacrificing equal units of utility (horizontal equity). However, difficulties arise in interpreting equal sacrifice rule for people with different incomes. How is the term ‘equal’ to be understood? In the tax literature the following three interpretations of the equal sacrifice rule are found.

  1. Equal Absolute Sacrifice.  It means the number of units of utility taken away from each taxpayer should be exactly the same.
  2. Equal Marginal Sacrifice.  The marginal sacrifice is the same, i.e. utility left with, rather than taken from, every taxpayer after tax should be the same. This will ensure minimum total sacrifice for society, and hence it is also called Least Aggregate Sacrifice Principle.

Equal sacrifice theory is based on vague assumptions. Utility, being a psychological phenomenon, is not only non-measurable for any one individual but also non-comparable as between individuals. In short, determination of a tax base capable of measuring an individual’s ability-t-pay is a major problem of tax theory. Yet this rule is incorporated in the form of progressive rate schedule for personal income tax, estate duty, and property tax worldwide. See also Benefit Principle of Taxation.

Assessment Year See Previous Year Versus Assessment Year

Assignment of Tax

Assignment of a tax means transfer of taxation power form a higher level to a lower level government. Taxation power includes the following: right to levy the tax, collect the tax, and appropriate the proceeds from the tax. Thus, there can be three interpretations of assignment of a tax. Firstly, higher-level government may levy and collect a tax but handover the entire proceeds to lower level governments. Taxes (e.g. estate duty) levied by the Government of India under Article 269 of the Constitution are a case in point. Secondly, the higher-level government may levy a tax but allow the lower level governments to collect is and retain fully the proceeds therefrom. Taxes (e.g. stamp duties) levied by the Government of India under Article 268 of the constitution fall under this category. Finally, the higher level government may transfer a tax to lower level governments lock stock and barrel, a situation which defines assignment of a tax in its strictest sense.

Generally, the purpose of tax assignment is to augment the resources of lower level governments. The assignment of tax may be conditional. Thus, it may be obligatory on the part of a lower level government to levy the tax assigned to it. Not only this, the lower level government may not have powers to alter the basic structure of the assigned tax. It may enjoy flexibility in fixing the tax rates within a minimum and maximum rage prescribed by the higher-level government.

Benefit Principle of Taxation

According to this traditional approach, an equitable tax system is one under which tax payments are based on the amount of benefits received from government services. In other words, the cost of government services should be apportioned among individuals according to the relative benefits they enjoy. Clearly, implementation of the benefit principle presupposes determination of the incidence of public expenditure before deciding distribution of tax burden. Thus it encompasses issues of both tax and expenditure policies.

Two objections are generally raised against the benefit principle of taxation, one on grounds of practicability and the other on considerations of desirability. As already noted, for implementing the benefit principle, the beneficiaries of public expenditure must be identified. This may be possible in the case of highway tolls, fishing and hunting licences, and property taxes. However, it is very difficult to allocate costs or benefits of the majority of government services among citizens. Who benefits from defence services, maintenance of foreign relations, space technology, or contributions to U.N.O.? Costs of these services cannot be divided and assigned logically to the recipients of the benefits. Most services of modern governments are provided in the interest of group rather than individual welfare. These difficulties limit the practicability of the benefit theory.

Even if it is possible to identify persons or classes receiving direct benefit from government services, it may not be desirable to tax them accordingly. This is particularly so in underdeveloped countries where tax policy is used as a tool of distributive justice. Governments in these countries have launched ambitious programmes, financed mainly through taxes, to solve the twin problems of unemployment and poverty. These welfare-oriented schemes include subsidized/free medical and educational facilities, low-cost housing, drinking water facilities in rural areas, land improvement schemes, and employment guarantee programmes. The beneficiaries of these schemes are not expected to compensate the government for the benefits received. Similarly, certain transfer payments (like scholarships to needy students or outright money grants to widows or handicapped) are financed from taxes and it would be ridiculous to expect the beneficiaries to contribute to public exchequer in line with the benefits received.

In short, tax policy is also an instrument of social change and not merely a charge for the services rendered by public bodies. The redistributive role of tax policy cannot be realized through benefit approach which is based on the implicit assumption of equitable distribution of economic power. Hence, the application of benefit theory of taxation is not widespread in the modern world. See also Ability-t-Pay Principle of Taxation.

Buoyancy and Elasticity of Tax Revenue

These terms refer to the degree of responsiveness of tax yield to changes in national income.

Tax revenue may change through automatic response of the tax yield to changes in national income and/ or through the imposition of new taxes, revision of the bases and/or the rates of the existing taxes, tax amnesties, stricter tax compliance and other administrative measures backed by legal action. Changes in the tax yield resulting from modifying tax parameters (bases, rates etc.) are called discretionary changes. Variations in the tax yield flowing from the combined effects of automatic responses as well as discretionary changes constitute the buoyancy of a tax. It is computed by dividing percentage change in tax yield by percentage change in national income.

With tax parameters held constant (i.e. discretionary changes being removed), automatic changes in the tax yield resulting from variations in the national income measure the elasticity of a tax system. It is the ratio of percentage change in tax revenue (adjusted for discretionary changes) to percentage change in national income.

With tax parameters held constant (i.e. discretionary changes being removed), automatic changes in the tax yield resulting from variations in the national income measure the elasticity of a tax system. It is the ratio of percentage change in tax revenue (adjusted for discretionary changes) to percentage change in national income.

Buoyancy estimates assess the overall success of government measures to increase tax revenues while elasticity coefficients indicate the inherent responsiveness of a tax system to changes in national income. In the absence or weakness of elasticity attribute of the tax system, a government will have to revise tax rates and tax bases every year to keep the share of tax revenue in national income undiminished. Such frequent changes complicate tax laws, reduce administrative efficiency and are also politically inexpedient. Therefore, tax structure should be so designed as to impart reasonable degree of elasticity to the tax system.

Objectives of Tax Policy

Taxation is a potent instrument to shape and influence the socioeconomic polices of a country. It is, of course, difficult to formulate a set of universally acceptable goals of tax policy because (a) different countries are in different stages of economic development, (b) objectives of economic policy differ in these countries, (c) priorities of economic policy continually change with the changing economic, social, and political milieu.

Though the concept of an ideal tax system for a country is linked with the peculiar characteristics of its economy, tax policy is usually assigned the following four functions in the stated order in a typical developing economy: resource mobilisation, resource allocation, distributive justice, and stabilization.

  1. Resource Mobilisation. The first and foremost objective of tax policy in a country is to raise resources for public authorities for administration and development. Taxes are the main instrument for transferring resources from private to public use. By designing an appropriate tax structure, resources can be raised from those who are holding them idly or squandering them on luxury consumption. According to Roy Gobin, “ the revenue criterion is usually the dominant consideration, since governments in LDCs have become increasingly aware of the active role which budgetary measures can play not only in initiating and promoting growth but also in maintaining political power. Not only are higher revenue levels needed, but also tax yields should be increased at a faster rate than income, if infrastructural investments and social welfare expenditures are to be financed without generating unacceptable inflationary pressures and/or increasing reliance on foreign assistance.”

The revenue performance, i.e. resources in developing countries calls for their optimum utilization. Since the composition of investment is an important determinant of growth rate of the economy, public policy must discourage the flow of resources to low priority areas so that they could be diverted to vital sectors of the economy. By imposing high tax rates on luxuries and other low priority items (such as motor cars, air conditioners, and jeweler), the government can discourage the consumption and production of such items, ensuring in the process release of resources for high priority sectors. Conversely, production of necessities of life and employment-oriented industries can be encouraged by offering tax concessions or even subsidies.

  • Distributive Justice. Distributive justice or economic justice is an important function of tax policy. Economic justice relates largely to distribution of tax burden and benefits of public expenditure. It is a component of the broader concept of social justice, which encompasses, besides distributive justice, such questions as treatment of women and children, and racial and religious tolerance in a society. Tax policy is a democratic method to influence the distribution of income and wealth on desired lines. The main ingredients of this policy can be (a) progressive direct taxation of income, wealth, and property transactions, (b) taxation of commodities (customs duty, excise levy, and sales tax) purchased largely by high-income groups, and (c) subsidies (negative taxation) on goods purchased by low-income groups.

Highlighting the importance of taxation and public expenditure policies in the context of redistribution of economic power, Alejandro Foxley has opined, “ modern public finance studies have de-emphasized the analysis of the normative considerations of theory and focused on the very basic question of incidence: who pays and who benefits from government action? Thus we can say that focus has shifted from question of what should the State do? To the question of knowing what in fact is has been doing?”

  • Stabilisation.  Initial developmental efforts are generally marked by inflationary tendencies in an economy. Inflation, if uncontrolled, may thwart all development plans and bring misery to the poor. A reasonable degree of price stability should be a primary concern of a government’s economic policies.

The overall level of economic activity in an economy depends upon aggregate demand, relative to capacity output. At times, the level of aggregate demand may be insufficient to secure full employment of labor and other factors of production. At other times, aggregate demand may exceed available output at full employment level. Government intervention in both the cases becomes essential to correct such disequilibria in the economy.

Monetary and fiscal policies are important instruments available to the government to ensure smooth functioning of the economy. Reduction in taxes during deflation would leave greater disposable incomes with the people, giving a boost to aggregate demand. The reverse is true in times of inflation.

The evaluation of a tax system with reference to the foregoing objectives in a difficult task because various other policies (like public expenditure policy) may be geared to achieve the same objectives. To what extent the redistributive objective has been served and what was the relative role of tax policy in it is a difficult question to answer. Moreover, the various objectives of tax policy may not always work harmoniously. Rather, they are often in conflict with each other if not mutually exclusive. Since the tax system of a country grows out of the interaction between political judgment and economic rationale, the process of compromises and trade offs is influenced by political expediency and economic logic, the former, in most cases, having the upper hand. In fact, political requirements and economic thinking change with time, giving new directions to tax policy. As Richard Bird has observed, “ Tax reform is, therefore, a never-ending process, not something that can be brought about once and for all and then forgotten.”

[i] Dr. Ikramul Haq, a leading international tax counsel, is a well-known author specialising in international tax, press, intellectual property, corporate and constitutional law. Dr. Ikram is Chief Partner of Lahore Law Associates (fax: +92 42 7226953, e-mail: irm@brain.net.pk; website: http://www.paktax.com.pk). He is a member of the visiting faculty of the Institute of Direct Taxes in Lahore. He served for 12 years as Deputy Commissioner of Income Tax. He studied literature, journalism and law, for his Masters and Doctorate degrees. He has written many books on various aspects of Pakistani law and global narcotics trade, some of which are co-authored with his wife, Mrs. Huzaima Bukhari, Additional Commissioner of Income Tax. He has been awarded Doctorate of Law for his research: Tax Reform in Quasi-Constitutional Perspective.

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