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October 16, 2018 

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VALUE ADDED: The increase in the value of a good at each stage of the production process. The value that's being increased is specifically the ability of a good to satisfy wants and needs either directly as a consumption good or indirectly as a capital good. A good that provides greater satisfaction has greater value. In essence, the whole purpose of production is to transform raw materials and natural resources that have relatively little value into goods and services that have greater value.

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ABILITY-TO-PAY PRINCIPLE:

A taxation principle stating that taxes should be based on the ability to pay taxes. The ability-to-pay principle works from the proposition that those who have the greatest income should pay the most taxes. The ability-to-pay principle is the only reasonable way to finance the provision of public goods such as national defense, public health, and environmental quality. This is one of two taxation principles. The other is the benefit principle, which states taxes should be based on the benefits received.
The ability-to-pay principle states that taxes should be based on the ability to pay taxes, that is, those who have more income should pay more taxes. This principle also makes a great deal of sense, especially for the provision of public goods that are consumed by all. If everyone benefits from public goods, without exclusion, then everyone should pay. However, not everyone CAN pay, so those who CAN afford to pay, need to bear the burden.

Fair and equitable application of the ability-to-pay principle also entails that those with the same income pay the same taxes and those with different incomes pay different taxes. These are termed horizontal equity and vertical equity, respectively.

A Transfer of Income

Taxes are a means of transferring the purchasing power of income from members of society to governments. Government is able to provide public goods and undertake government operations if it has command over resources. This command is achieved with taxes, with the transfer of income from members of society. Income can only be transferred from those who have income. This is the basis for the ability-to-pay principle.

Taking this notion a step further, those who have more income can afford to pay more taxes, that is, they have a greater ability to pay. In addition, even though taxes are imposed on a wide range of tax bases (sales, property, wealth), all taxes are ultimately paid with income. The ability-to-pay principle then implies that the best generate the revenue needed for government operations is collect taxes on income, ALL income without exclusion. All income should be included, not just wage earnings, or corporate profits, or income used for consumption, or just the income remaining after a myriad of special deductions or exemptions.

A Matter of Efficiency

In fact, the only efficient way to provide public goods, goods that are nonrival in consumption, is through the ability-to-pay principle. Because efficiency requires that public goods be provided at a zero price to members of society, tax payments cannot be in any way attached to who benefits. If tax payments are perceived as a price based on benefits received, then efficiency is not achieved. The revenue generated to finance the provision of public goods must be based on some other criterion. The ability that members of society have to pay taxes is as good as any and better than most.

Equity: Horizontal and Vertical

The ability-to-pay principle has two additional criteria. It also seems "fair" and equitable that those with the same ability to pay should pay the same taxes and those with different abilities should pay different taxes. More specifically these are termed horizontal equity and vertical equity.
  • Horizontal Equity: This tax equity principle states that people with the same ability to pay taxes should pay the same amount of taxes. Suppose, for example, that Jonathan McJohnson earns $50,000 of income as a junior executive at OmniConglomerate, Inc. and pays $5,000 income taxes, a rate of 10%. Horizontal equity results if Manny Mustard, the proprietor of Manny Mustard's House of Sandwich, pays a like $5,000 of taxes on a like $50,000 of income earned from his sandwich-making business.

  • Vertical Equity: This tax equity principle states that people with a different ability to pay taxes should pay a different amount of taxes. Once again, let's say that Jonathan McJohnson earns $50,000 of income as a junior executive at OmniConglomerate, Inc. and pays $5,000 income taxes, a rate of 10%. Vertical equity results if Lisa Quirkenstone, a clerk at the MegaMart Discount Warehouse Supercenter, pays $500 of taxes on $5,000 of income earned from her job, also 10%. Jonathan has greater ability and pays more taxes.

Benefit Principle

An alternative to the ability-to-pay principle is the benefit principle, which states that taxes should be based on the benefits received, that is, those who receive the greatest benefits should pay the most taxes. On the surface, this principle is quite logical and easily justified. The people who benefit from public goods are logically the ones who should pay for their provision. Drivers should pay for highways, library patrons should pay for libraries, students should pay tuition, camping enthusiasts should pay for national parks, and the list goes on.

However, the benefit principle does not work well for the efficient provision of public (and near-public) goods. Due to nonrival consumption, such goods are efficiently allocated with a zero price. If those who benefit directly from a public or near-public good pay a price equal to the value derived, as would be the case for private goods, then the "quantity demanded" declines and so too does the overall level of benefit generated. This is not efficient.

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Recommended Citation:

ABILITY-TO-PAY PRINCIPLE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: October 16, 2018].


Check Out These Related Terms...

     | tax equity | ability-to-pay principle | taxation principles | taxation basics | horizontal equity | vertical equity | tax proportionality | proportional tax | progressive tax | regressive tax | tax effects | revenue effect | allocation effect | tax efficiency | tax incidence | tax wedge | deadweight loss |


Or For A Little Background...

     | taxes | government functions | efficiency | equity | distribution standards | public finance | allocation | normative economics | economic goals | public goods | near-public goods | consumption rivalry | nonpayer excludability |


And For Further Study...

     | public choice | good types | market failures | public goods: demand | public goods: efficiency | tax multiplier | personal tax and nontax payments | transfer payments |


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