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 Principle

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 Principle

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 Fro

• 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.