Principle of ability to pay as a canon of taxation
The most important principle of taxation is the principle of equity or equality. Adam Smith has placed the canon of equality in the fore-front. The rest of the canons are merely of administrative nature. Therefore, this canon may be called the principle of taxation.
The proper distribution of the burden of taxation is one of the fundamental problems in the public finance of modern democratic Slates. The question of what ought to be done in order to secure fair distribution is obviously an ethical one. But its correct solution is so bound up with economic and financial considerations that it also belongs essentially to the-sphere of financial inquiry. Unless we know the direct and indirect effects of a given tax or tax system, we are unable to form a judgment respecting its justice. Nor is it enough for a tax system to be substantially just, objectively speaking. It ought also to be generally known and recognized as such, for, even when unfounded, the belief that the public burdens are not fairly apportioned between different classes of individuals may cause great disorder in society.
But the trouble is that although everybody is agreed that a tax should be just and that it should be graduated according to the ability to pay, yet there is no unanimity as to what is the correct measure of equity in taxation. In this connection, several proposals have been put forward.
Purchase Theory. The first and the simplest principle for the distribution of taxation would be to treat it as a payment for public services and a payment equal the cost of the services rendered. The idea of purchase and sale between the citizen and the State leads to untenable conclusions respecting the nature of the State.
This theory is open to many objections. Firstly, the method of specific payment public services does not result in justice in the distribution of the burden of taxation. Take for example, national defense, legal administration, or general economic activities of the State. In all these cases, it is not possible to distributed advantage among individuals and to charge them in proportion.
Benefit theory: This theory maintains that justice in taxation is secured by taxing each citizen in proportion to the benefits he derives from the activity of the State. (This is also known as the insurance theory or the quid pro quo theory of taxation.)
The Benefit Theory is open to the following objections: Firstly, the weak and the poorer people receive great benefits from the government in the form of free education, etc. Though they receive the greatest benefit, they are, however, least able to bear the burden of taxation. It would be unjust to tax the poor in proportion to the benefits derived by them. Secondly, it would be impossible to determine the proportion of the general benefits of government expenditure that accrue to particular individuals. The Benefit theory really applies not to taxes but to other public charges like fees, special assessments, etc., which are generally levied in proportion to benefits received by persons making these payments.
Theory of Equal Sacrifice. Another suggestion to make a tax satisfy the principle of justice is that we should take into consideration the sacrifice entailed by the tax-payer. The State should see that the tax subjects the tax-payers to an equal sacrifice. This aim is realized by introducing the principle of progression in the tax system. It is also suggested that the tax should impose the least aggregate sacrifice. But this will be possible only if we impose very heavy taxes on a few rich people and leave the general public entirely free from taxes. This is not at all feasible. Such a heavy tax will discourage saving and enterprise, and it will have very serious and harmful repercussions on public in general.
Ability Theory. The solution to the question of justice in modern taxation mainly depends on the concept 'ability to pay'. But the difficulty is to determine how this ability to pay can best be measured. Should it be in respect of Property, Income or Expenditure? These objective tests of ability to pay are discussed below.
Some have suggested that if a tax is imposed according to the property that a person possesses, it will be equitable. But property is not a correct index of a person's ability to pay. One person may possess one dozen houses from each of which he gets a monthly rent of Rs. 100, whereas another person may have one centrally situated building from which he may be getting Rs. 1500 as rent. Hence, we cannot be merely guided by the extent of a man's property while imposing a tax.
Another measure of a person's ability to pay is said to be his expenditure. It is argued that if a man is able to spend a very large amount, he must be in a position to pay a very high tax. This is a wrong conclusion. A man may have to spend a large amount of money because he has a large number of dependants. Expenditure, therefore, as an indicator of a person's ability to pay must be rejected.
A single best test of a person's ability to pay is his income. But here again a single tax on income will not be sufficient. In practice it will have to be supplemented by a number of other taxes. We may not be able to make every single tax conform to the canon of equality or equity. But what is wanted is that the tax system as a whole should be a just one.
It is clear that it is not fair to base taxation on any single test of ability to pay. Each criterion has some defect from the point of view of equality. It may, therefore, be concluded that any single test of ability, whether it be the amount of income or of capital or saving or expenditure, or anything else is bound to be defective.