NEEDS STANDARD: One of three basic income distribution standards (the other two are contributive standard and equality standard). The needs standard distributes income based on how many goods and services people require. A manual laborer, for example, who exerts more physical effort, would receive more income to buy more food that an office worker who burns fewer calories during the day. The U.S. welfare system primarily employs this needs standard when determining the poverty line and subsequent welfare payments.
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The notion that taxes are imposed on society in a fair and equitable way. The two standards of fairness and equity used to evaluate taxes are the benefit principle -- those who benefit from government pay the taxes, and the ability-to-pay principle -- those with the most income pay the taxes. The ability-to-pay principle gives rise to two additional notions of fairness -- horizontal equity (those with equal incomes pay equal taxes) and vertical equity (those with different incomes pay different taxes). Taxes necessarily transfer income and purchasing power from members of society to governments. Without tax revenue, governments could not undertake essential government functions, including national defense, education, and public health. While no one particularly enjoys paying taxes, the task is less objectionable if people think that the taxes are collected in fair and equitable fashion.
What is considered fair and equitable, however, is subject to debate. The two most noted standards are the benefit principle and the ability-to-pay principle. The benefit principle states that taxes should be based on the benefits received, that is, those who receive the greatest benefits should pay the most taxes. 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.
The benefit principle is most commonly used for near-public goods in which those who benefit can be readily identified and nonpayers can be excluded from consumption. The ability-to-pay principle is used for public goods in which those who benefit cannot be readily identified and nonpayers cannot be excluded from consumption.
Two additional criteria that arise from the ability-to-pay principle are horizontal equity and vertical equity. Horizontal equity states that people with the same ability to pay taxes should pay the same amount of taxes. Vertical equity then states that people with a different ability to pay taxes should pay a different amount of taxes.
The Benefit PrincipleThe first of two key tax equity principles is the benefit principle. The benefit principle 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.
The benefit principle is consistent with the market side of resource allocation, and is thus quite appealing to both economists and the general public. If Duncan Thurly never uses the Shady Valley Municipal swimming pool, then why should he pay for it?
This principle of tax fairness is most often applied to near-public goods that are characterized by nonrival consumption and the ability to exclude nonpayers, such as turnpikes, college education, and public parks. Because nonpayers can be excluded from consuming near-public goods, tax payments (entrance fees, tuition, etc.) can be based on the benefits received.
There is, however, a major problem with the benefit principle. It does not work well for the efficient provision of either public or near-public goods. While it can be used to set the price of near-public goods, doing so does not generate efficiency either. 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 according to the law of demand the "quantity demanded" declines and so too does the overall level of benefit generated. This is not an efficient outcome.
Using the benefit principle for public goods is more exceedingly difficult to implement. Due to the inability to exclude nonpayers from consuming public goods, identifying the benefits received, which would then be the basis for setting the amount of the tax, is virtually impossible. While everyone benefits from national defense, does everyone benefit equally? If not, then who benefits more? And can this be translated into different tax payments?
The difficulty in answering these questions gives rise to the second tax equity principle.
The Ability-to-Pay PrincipleThe second of two key tax equity principles is the ability-to-pay principle. 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.
Because taxes are a means of transferring the purchasing power of income to governments, the ability to pay is based on income. Those who have more income can afford to pay more taxes, that is, they have a greater ability to pay. While taxes are imposed on a wide range of tax bases (sales, property, wealth), the more efficient taxes for public goods are those based on the broadest notion of ability to pay, which is income. And 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.
In fact, the only efficient way to provide public goods 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.
Ability: Up and Down, To and FroThe 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 this is 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.
TAX EQUITY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: February 26, 2024].
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