Problems and Principles of Equity in Taxation

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 Principle

The 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 Principle

The 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 Fro

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 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.

Equity is basic criterion for every tax – structure design. Every one agrees that the tax system should be equitable, ie. that each tax payer should contribute his fair share to the cost of government. But there is no such agreement about how the term fair share should be defined. 
                                                                                                                          
                        Generally speaking, equity in taxation means equitable or just distribution of burden of tax among members of the society.

                        A number of approaches are there which deal with the problem of equity in taxation. Of which, 2 approaches are important. They are:

1. Benefit approach / principle (BP)

1. Ability – to – pay approach / principle (AP)

A)                               Benefit Principle

                        According to the principle of benefit, the burden of taxation must be in proportion to the benefit received by a person from the expenditure made by the government. The persons who are receiving equal benefits from the government should pay equal amount as taxes and those who are receiving greater benefits should pay more as taxes than those receiving less benefits.

                        The government should not impose taxes greater than the benefits received by the tax – payer. If the taxes are greater than the benefits received, then the tax system would not be equitable one.

                        In other words, Tax is the price for the services given by the government to the people. So the tax (or price) should be equal to the benefits received (or satisfaction or utility derived).

                        The principle can be illustrated with a diagram:

                        AB is the tax benefit line. When OP benefits are given to the people, government imposes taxes corresponding to the benefits received. Thus OM tax is imposed as per the tax benefit line. Suppose due to the increased government expenditure, benefits received by the society increases from OP to OP1. Government also increases tax by a corresponding amount, as stipulated by the tax benefit line. Thus tax increases from OM to OM1. Suppose to the OP1 benefits, government imposes a tax OM2. Then, tax will be more than the benefits generated. Then we can say that OM2 taxation violates the principle of tax equity.
                       
(Diagram on the next page.)

 

Limitations of Benefit Principle

1. The principle is based on the assumption that varied and complex activities of the government should be calculated against each individual on the basis of benefit received. For example: the benefits available to each individual is very difficult to calculate separately in case of public expenditure like defence expenditure, fire force, expenditure in advanced scientific research etc.

1. Under this principle, government do have the correct information about the exact amount of benefits received by each individual. But there is no mechanism is present to get such information. The person himself alone knows, the amount of benefits he receives. So the application of this principle, requires, revealation  of benefits by each individual. But people would not disclose such information when he knows that, the amount of tax he has to pay is depend upon the amount of benefit he receives.

1. In modern times, government is welfare oriented and tries to provide all sorts of service with the objective of increasing the welfare of the society as a whole. It is impossible to generalize the benefits rendered to the society.

1. Generally benefits are received by the community as a whole. Therefore, an individual cannot be taxed but the taxation should be taken as a collective instrument for supporting the services of the government.

1. The principle states that rich and poor people should pay equal tax for the same benefits received. But the Marginal Utility of income of rich people is lower than the poor people. So it is unjust to tax both rich and poor equally.

1. One of the objectives of tax policy of government is to rectify the differences in distribution of income between rich and poor. But benefit principle ignores this objective. If re – distribution of income is the objective of taxation, government should take away income from rich people by way of higher taxes and give it to poor people. But benefit principle does not allow to impose higher taxes more than the benefits received.

1. Adam Smith is the major exponent of Benefit Taxation. His argument that every person should give as much amount of tax as equal to the protection given by the government. But John Stuart Mill criticised this reasoning. He argued that poor people received more protection from government than that of rich people. So, if this principle is implemented poor would pay more tax than rich. Mill says that it is contrary to the idea of Justice in taxation.  

Advantages of Benefit Principle

1. Specific Benefit Taxes: - It is most suitable method of taxation to deal with specific public projects. For example: The taxation of bridges, roads etc. They are public expenditures. In these specific cases, it is easy to implement tax according to the benefits received. Such taxes are often called as toll, fees, user charges etc.
2. The benefit principle may be used by the local governments to determine special assessment of the persons who are benefited from the local public works.
3. Swedish Economist Nutt Wicksel and Erick Lindahl argue that, through their voluntary exchange model, it is most just solution to the problem of taxation.
4. In the absence of benefit taxation, it is impossible to tax persons who are benefiting from a specific government project. For example: If the government does not follow the principle of benefit, and imposes tax on the basis of ability to pay, then it would end up in imposing tax upon people in Kerala for meeting the expenditure of a bridge constructed in Delhi. Thus persons who do not use the bridge are made worse off. This unfairness in taxation can be avoided, if the government follows the benefit principle. In other words, benefit alone satisfies the criterion of equity in such cases.

 

Conclusion

                        From the above analysis it is clear that, this principle lacks universal applicabilities. But in some specific cases, this principle can be easily implemented. More over, in such situations, benefit principle alone satisfies the criteria of equity.

B)                               The Ability to Pay Approach

                        The principle of Ability to pay means that the burden of tax is distributed among members of the society according to their ability to pay taxes. Ability is estimated on the basis of income, ownership of property, wealth, consumption etc.

                        Major supporters of this principle are John Stuart Mill, JB Say, and Rousseau.

Evolution and Background of Ability to Pay

                        While discussing the benefit principle we have explained the objections raised by JS Mill against benefit principle. He argued that benefit principle produced results contrary to the idea of justice in taxation. This led Mill to reject the benefit principle and to advocate for the principle of ability to pay.

Rationale for Ability to Pay (a – t – p)

(i) Concept of Equality in Sacrifice

                        According to JS Mill, equality in taxation means equality in sacrifice of welfare / utility / satisfaction. Since, Marginal Utility of income declines as income increases, equality in sacrifice requires progressive taxation which can only be achieved through this principle.

                        Progressive tax is that tax, whose rate increases as income increases. For example: To an annual income of Rs. 50,000 one has to pay 20% tax. While to an annual income of Rs. 150, 000, one has to pay 30% tax.

(ii) Law of Diminishing Marginal Utility (MU) of Income

                        It says that Mu of income falls as income increases. For example: Suppose that ‘A’ has Rs. 100,000 per annum and ‘B’ has an income Rs. 10,000 per annum. The Mu of an additional of Rs. 100 to ‘A’ and ‘B’ differs. To ‘A’, Mu of Rs. 100 might be between Rs. 60 – 70. While to ‘B’ it might be Rs. 120 – 140. That means, we can easily take back more income from rich people without inflicting much burden upon them. Hence taxes can be imposed on the basis of a – t – p.

(iii) Interpretation of Faculty

                        Another justification of ability to pay is based on faculties interpretation. It represents the capacity of an individual to produce and consume and this is represented by the income and the accumulated wealth of the individual. After meeting certain basic needs, the individual is left with certain resources, which reflect a high degree of tax paying capacity. According to Hubson, it can be called as economic surplus. According to him, economic surplus is the part of the income, which can bear the tax burden.
                    Hot withstanding these three arguments, it is the simplicity and applicability of this approach, brought in wider acceptance popularity. 

Equity and the Principle of Ability to Pay

                        An important problem regarding the implementation of this principle is that how we can observe “fairness” in its application. In other words, how we can achieve a “fair” distribution of burden of tax under a – t – p approach. More specifically, the question is how can observe “equity” or “justness” in taxation under a – t – p approach.

                        To confront this problem alternative concepts of equity have been derived. They are the concepts of

1. Horizontal Equity
2. Vertical Equity

Horizontal Equity

                        Horizontal equity in taxation means, same tax rate is applicable to all individuals who are identical in all relevantrespects. Identical in all relevant respects implies equal on income level, or capacity, age and marital status. Only for sake of simplicity, we consider these three criteria as a basis. These three are the most acceptable parameters of basis for the application of horizontal equity. Still, problems are plenty with even these three criteria. For instance suppose ‘A’ and ‘B’ have same level of income ie, ‘A’ and ‘B’ are identical in all relevant respects. So the government impose 20% tax upon both. Suppose that ‘A’ has a daughter who has been affected by an acute heart disease. So ‘A’ has to spent a larger portion of his income as medical expenses. In such situations, can we say that, imposition of same rate of tax upon ‘A’ and ‘B’ is “fair” or “just”? Certainly it is not. To achieve, we have impose a reduced tax upon ‘A’. Now – a – days up to a certain extent government gives tax exemption to medical expenditure. Such exemptions are allowed by the government for achieving the principle of horizontal equity in taxation. Another popular example is the exemption given to interest on housing loan up to Rs. 150,000.

Vertical Equity

                        Vertical equity means imposition of higher rates of tax upon people who have higher a – t – p and lesser rates upon people who have less a – t – p.

                        How the question is what determines a – t – p? Whether it is income, wealth, property, consumption etc?

 

Income as a Basis

                        It is the most widely used basis of taxation. There is a widely held view that these with higher income should not only pay more taxes but should pay a higher proportion of income as taxes also. Put otherwise, taxes should be progressive in nature.

                        The major advantage is that it is easy to implement since income of every person can be easily estimated. No complex or indirect methods are required to compute ones’ income. But in case of wealth or consumption as tax base, we have to find answer to all these problem.

                        However, the major disadvantage is that it is inequitable because it involves double taxation of saving. Suppose that a person has Rs 10,000 as income. He consumes Rs. 8,000 and saves Rs. 2,000. A 10% income tax is applicable to his total income Rs. 10,000 and so he pays Rs. 1,000 as tax. Suppose the saved amount of Rs. 2,000 earns a 10% interest. That is in the end of that year he gets Rs. 2,00 as interest. Interest is one form of income and so 10% tax is applicable to Rs, 2,00 also. He ends up by paying Rs. 20 as income tax upon the saving, even though he had been already paid a tax upon his initial income of Rs. 10,000.

                        Further more, saving and investment constitute social acts which are advantageous to the society as a whole.

                        But the important objection is that saving is not an attruistic act. It is simply a postponement of present consumption. So there is no double taxation.  

Consumption as Basis

                        According to some economists, taxes should be imposed on the basis what, different individuals take out of the societyrather than what they contribute to the society. So, according to them, tax on income is not just.

                        What individuals takes out from the society is called as “Consumption” and what they contribute is regarded as “Income”. So supporters of this view, argues that consumption should be taken as the basis for taxation.

                        Moreover, the difference between income and consumption is referred as “Saving”. Whatever portion of income that is not spend on consumption takes the form of saving. Thus to some economists, the real problem of a choice between income and consumption is that whether savings ought to be exempted from tax or not.

Wealth as Basis

                        The third major alternative to income and consumption as the index of ability to pay is wealth. Accumulated wealth influences the standard of living of a family. A family which posses a large property can enjoy a high level of living with doing any work at all. This is the main argument for considering wealth as the basis of taxation.

                        So far we discussed different indices to the term ability to pay. We have already said that horizontal equity refers the taxation of the people who are identical in all relevant respects with equal rates. The relevant respects are:

1. Age
2. Income
3. Marital Status

A lot of discussion is undergoing in considering “income” as one relevant aspect. Many economists argue that income (as an index of ability or as a relevant respect) is not an appropriate basis. They argue that consumption and wealth should also be considered as index of ability or as relevant aspect. That is why we discussed all these things. To conclude, generally income is considered as the most acceptable index of ability as it is the easiest one to measure although the above said disadvantages are present in it.

Vertical Equity and The Principle of Ability to Pay (The Sacrifice Rules)

                        Vertical equity implies, people with higher ability should pay taxes at higher rates and vice versa. Now the question what should be rate of tax which satisfies the principle of vertical ability. In other words, the problem is how to determine, the amount of tax payable by individuals who have different levels of income. 

Equal Sacrifice Rules

                        According to John Stuart Mill, the condition of equity can be fulfilled if the tax payments involve an equal sacrifice of income or loss of welfare to all tax payers. Loss of welfare is measured on the basis of marginal utility of income. In short, equity in taxation means equity in sacrifice.
                        Here we make two assumptions:

1. Marginal Utility of income is known
2. It is same for all people.

By using the marginal utility of income schedule we determine the amount of tax payable by each individual who have different levels of income.

                        The amount of tax payable by each individual will differ under this approach on the basis of

1. How we interpret the term “equal” is “equal to Sacrifice Rule”.
2. The shape of marginal utility of income schedule. (we consider only the first aspect)

Alternative Rules

                        The term “equal” in the equal sacrifice rule is interpreted in 3 ways.

1. Equal absolute sacrifice ie, the total amount of sacrifice should be equal.

1. Equal proportional sacrifice ie, the sacrifice of all individuals should be on the same proportion.

1. Equal marginal (least aggregate) sacrifice ie, the marginal sacrifice of all individuals should be equal. Then we can say that the aggregate sacrifice of the society will be least.

These 3 rules can be explained on the basis of the diagram given below. Figure (A) represents a low income group (LIG) person and figure (B) represents a high income group (HIG) person. MUL and MUH are respective MU schedule of LIG and HIG. Both are identical as per our earlier assumption. (The only difference is, MU schedule of HIG is longer than that of LIG but still have the same slope). MU of income declines at a declining rate that is why both MU schedules falls continuously.

                        Total income of LIG is OA before tax. The welfare or total utility he enjoys is represented by the area OA4S. Similarly, to the HIG OM is the total income before tax and total welfare or utility is OM6K.

                        Now suppose that the government decides to start a new project. It needs revenue and for it, imposes a tax upon people to raise the required revenue “T”. Let us see how the tax burden “T” is distributed among the people under each rules, all of them satisfies the concept of vertical ability under ability to pay approach.

(i)           Equal Absolute Sacrifice

                        It means the sacrifice or loss in utility (since welfare is measured in terms of utility) of LIG and HIG should be same. Government imposes tax upon both, in such way that the sacrifice or loss in utility should be equal to LIG and HIG.

                        Thus government imposes BA tax (refer diagram) on LIG and NM upon HIG. BA + NM = the required revenue “T”. Since BA and NM represent tax to LIG and HIG, it also represents the sacrifice or loss in utility borne by LIG and HIG. Thus 
Sacrifice \ loss in utility to LIG = B14A.
Sacrifice \ loss in utility to HIG = N76M.
                        Thus the government distributes the burden of tax “T” in such a way that the sacrifice of both will be the same.

                        How the next question is to find out whether this situation calls for a progressive taxation. As the MU schedule falls, (ie, as MU of income falls) if we have to equate the absolute sacrifice (or face value of sacrifice) we have to take back more income as tax form the rich people.

                        For example: Suppose ‘A’ has Rs. 1,000 and ‘B’ has Rs. 10,000 as monthly income. The MU Rs. 100 to ‘A’ might be Rs. 150 while to ‘B’ it might be Rs. 50. Now the government decides to take back Rs. 100 from ‘A’ as tax. The sacrifice involved is equal to Rs. 150 as ‘A’ derives that much utility from it. In this situation, if the government wants to equate the (face value) absolute sacrifice of both persons, the government has to take back more income ie, Rs. 300 from ‘B’. Because ‘B’ derives only Rs. 50 as MU for additional Rs. 100.

                        In other words, when MU falls, tax burden must rise with increase in income. This much is clear, but it does not follow that a progressive tax will be called for. It depend on whether the elasticity of MU of income with respect to income. If it is,

Greater than one    (> 1)   à   Progressive tax
Equal to one        (= 1)   à   Proportional tax
Less than one                  (< 1)   à   Regressive tax, will be imposed.

This is so because even though it seems reasonable to assume that the MU of income falls, there is no answer about its rate of decline.

                        For example: Suppose a person’s income increases by Rs. 1 – if the MU of that Rs. 10 increases by 1, the ‘e’ of MU of income with respect to income is equal to 1. If the MU increases only by 0.7 the ‘e’ MU of income with respect to increase in less than 1. But if the MU of income falls by 0.2 (ie, - 0.2) the ‘e’ of MU of income with respect to income is greater than 1. So in this case, we have to take back a more than proportionate income to equate with the sacrifice of LIG. That is, in this case only we can adopt a progressive tax rate. 

(ii)          Equal Proportional Sacrifice

                        This rule requires the equality of percentage of sacrifice to the initial level of welfare. This can be fulfilled if the following condition is observed.
Sacrifice of LIG   =   Sacrifice of HIG
Welfare of LIG          Welfare of HIG

                        In the earlier rule, we said that B14A = N76M. OM is greater than OA, as OM pertains to HIG. Then we can safely say that, the percentage of sacrifice of HIG to the initial income is smaller to that of LIG. In other words,
                                    N76M  <  B14A
                                    OK6M     OS4A
So to equate the % of sacrifice of LIG and HIG, we have to increase the sacrifice of HIG. Thus we increased the tax upon HIG from NM to PM. Earlier we said that BA + NM = T (the required revenue). Then BA + PM is greater than ‘T’. We need only ‘T’. So we have to reduce the amount of tax upon LIG. Thus we reduces the tax upon LIG from BA to CA. Then the % of sacrifice of each person to their initial welfare will be equal ie,
                                    C24A   =   P86M
                                    OS4A       OK6M

                        Here also, whether a progressive or proportional tax is required is depend upon the exact shape of MU of income schedule \ curve.

(iii)         Equal Marginal Sacrifice

                        Under this rule, we equate the marginal sacrifice of both individual. It can be achieved if the tax of LIG is DA and HIG is RM. Them the marginal sacrifice ie, D3 for LIG and R9 to HIG are equal.

                        From the diagram, under this rule, it is self evident that HIG pays the largest amount of tax (ie RM) and LIG pays much less (ie DA). This rule calls for a maximum progressive tax. Then only we can equate the marginal sacrifice.

Conclusion

                        Comparing the results for LIG and HIG, LIG does best under the equal marginal rule (or pays less as tax) followed by equal proportional and equal absolute sacrifice. It is also evident that HIG pays more tax than LIG in all the three cases. This simply reflects the declining slope of the MU of income.

                        Moreover, under the equal marginal sacrifice, the total sacrifice of the society is least when compared to the other two rules. So it is also called as the principle of Least Aggregate sacrifice.

                        Last, but not least, this is a subjective approach to solve the problem of vertical equity under ability to pay approach. The reason is that, we follow the concept of marginal utility which is a psychological phenomenon.