Measuring the Ability to Pay: Subjective and Objective Approach

After reading this article you will learn about the subjective and objective approach used for measuring the ability to pay.

Subjective Approach to Measure the Ability to Pay:

The ability to pay principle is interpreted in terms of sacrifice on the part of the taxpayers. Payment of tax involves some sacrifice on the part of the taxpayers. Each taxpayer should make equal sacrifice if tax burden is to be distributed equally.

Prof. J. S. Mill viewed the ability to pay rule in terms of an equal sacrifice prescription. Accord­ing to Mill “taxpayers are said to be treated equally if their tax pay­ments involve an equal sacrifice or loss of welfare”.

A fair system of taxation based on the ability to pay approach is defined as one where the sacrifices of utility by all taxpayers are equal. In other words, taxpayers are said to be treated equally if these tax payments in­volve equal sacrifice, or loss of welfare.

Equal sacrifice rule involves that people with equal incomes should contribute equal amount of tax. It means realization of horizontal equity. The principle further states that people with different incomes should pay different amount as taxes. It involves realization of vertical equity.

However both are part of the same principle of equal treatment. That is taxes should impose equal sacrifice. The equal sacrifice principle can be inter­preted in three distinct ways, as explained by Cohen Stuart and Edge worth.

They are:

(a) Equal absolute sacrifice,

(b) Equal propor­tional sacrifice, and

(c) Equal marginal sacrifice.

(a) Equal Absolute Sacrifice:

This principle requires that the absolute amount of real burden due to payment of tax should be equal for every taxpayer.

The total loss of utility due to tax payment should be equal for all taxpayers. The rich may contribute more as taxes. One who has less income will pay less as taxes. But the sacrifice to both as a result of the tax should be equal.

(b) Equal Proportional Sacrifice:

This condition requires that the total loss of utility due to tax pay­ment should be equal for every taxpayer. Here the sacrifice should be proportional to income, rather than equal at all income levels.

The rationale of the proportional sacrifice doctrine was the argument that persons with greater incomes received much more benefit from soci­ety. Hence they should bear more tax sacrifice rather than the same amounts as persons with smaller incomes.

Thus for example, under the equal sacrifice doctrine, a person with Rs. 50000/- income would be taxed so as to bear the same real burden as a person with Rs. 25000/- income.

Under the proportionate doctrine, the former would be made to bear twice the sacrifice. That is the ratio of real burden will be the same for all. Thus the ratio: Loss of utility due to tax/ utility of pre-tax income should be equal for all taxpayers. For ex­ample, suppose there are two taxpayers G and H.

The income utility of ‘G’ and ‘H’ are measured at 200 units and 100 units respectively. If taxpayer ‘Gs’ loss of utility due to tax payment amounts to 20 units i.e. 10% of pre-tax income utility. Then to realize proportional sacrifice, taxpayer ‘H’ will have to pay 10 units, to equalize the loss of utility of pre-tax income with ‘G’ (i.e., 10%).

(c) Equal Marginal Sacrifice or Least Aggregate Sacrifice:

The third version was the minimum aggregate sacrifice or equimar­ginal sacrifice doctrine. This principle states that persons should be taxed in such a manner that the total sacrifice for society would be kept to the minimum possible extent. This in turn required that the adjustment of taxes ensure that the marginal sacrifice, i.e., the disutility arising from the payment of the last rupee of tax would be the same for all persons.

If this point were not attained, the shifting of tax burden from some persons to others would reduce the sacrifice of some persons more than it increased the sacrifice of others and thus lessen aggregate sacrifice. Suppose there are two taxpayers in a community – tax payer ‘G’ and H’. Let ‘U’ stands for total utility and ‘Y’ stands for income and T for tax amount. Then (Y-T) indicates income after tax.

Now we can express the three concepts of equal sacrifice principle in the following way:

(a) Equal absolute sacrifice principle can be expressed as:

U(Y)-U(Y-T)G =U(Y)-U(Y-T)H

(b) Equal Proportional Sacrifice Principle can be mathemati­cally stated as:

Graphical Explanation of Equal Sacrifice Principle:

A diagrammatic explanation of the above three concept of equal marginal sacrifice principle is given below. Diagram No. 4.3, provides a detailed presentation of the principle in a simple and lucid manner. Low income tax payer ‘L’ High income tax payer ‘H’

The left diagram pertains to low income taxpayer ‘L’ and the right diagram to high income taxpayer ‘H’. Mu_L and Mu_H are the respective marginal utility of income schedule. These schedules are identical and assumes to decline at a decreasing rate.

Taxpayer ‘L’s income before tax is OB and that of taxpayer ‘H’ is OB_r The total utilities derived by tax payers ‘L’ and ‘H’ are OBDM and OB¹D¹M¹ respectively. Now the figure explains the situation under which tax burden is to be allocated among the two taxpayers ‘L’ and ‘H’.

The question is if a given tax revenue T is to be collected from the two taxpayers how will it be allocated among the two taxpayers under the three rules of equal sacrifice principle: (a) Equal Absolute Sacri­fice, (b) Equal Proportional Sacrifice and (c) Equal Marginal Sacri­fice.

1. Graphical Explanation of Equal Absolute Sacrifice:

Under this rule, taxpayer ‘L’ with income OB pays CB amount of tax, while taxpayer ‘H’ with income OB¹, pays C¹ B¹ amount of tax. CB+ C¹B¹ constitute the total tax revenue T.

The loss of utility or sacri­fice suffered by ‘L’ equals CBDE and that of H equals C¹B¹D¹E¹. Hence under this principle, the total tax amount T will be distributed in such a way that

CBDE = C¹B¹D¹E¹

2. Graphical Explanation of Equal Proportional Sacrifice:

If the total tax burden ‘T’ is distributed as per this rule, taxpayer ‘L’ will pay PB and taxpayer ‘H’ will pay P¹B¹ quantity, with (PB+ P¹B¹) again equals to T. The tax is divided between the two in such a way that the fraction of pre-taxed utility lost for tax payer ‘L’ (PBDK/ OBDM) is the same as that for taxpayer ‘H’. (P¹B¹D¹K¹/0¹B¹D¹M¹).

3. Graphical Explanation for Equal Marginal Sacrifice:

Under this rule, taxpayer ‘L’ pays FB and taxpayer ‘H’ pays F¹ B¹ and (FB + F¹ B¹) corresponds to the total tax revenue ‘T’. Here the marginal sacrifice is the same for two taxpayers, since FG = F¹G¹. At the same time, two total sacrifice for both (FBDG + F¹ B¹D¹G¹) is minimized. After taxed incomes as per this rule are equalized at the point where OF = O¹ F¹.

Conclusion:

Comparison of results for taxpayers ‘H’ and ‘L’ reveals that taxpayer ‘L’ does best under the equal marginal rule, followed by equal propor­tional and equal absolute sacrifice rules. Another fact is the tax­payer ‘H’ being rich, pays more than taxpayer ‘L’, whatever rule is chosen. This is an indication of the declining slope; of the marginal utility schedule. Moreover the tax formula will be progressive under equal marginal rule.

Limitations of the Subjective Approach:

The subjective approach to ability to pay theory has serious limita­tions. It is very difficult to equalize the marginal sacrifice of different taxpayers, because of a change in their attitude, taste, preference, temperament etc.

It is a highly changing phenomenon. Moreover sacrifice being a psychological phenomenon, is incapable of accu­rate measurement. Hence, subjective approach is an ideal approach which ignores the realities of practical life.

Moreover subjective ap­proach is not scientifically true. In this context Prof. Musgrave ob­served it remains to be seen whether a workable and reasonable measure of utility can be developed in time and whether thereby the subjective concept of ability to pay can be given an operational mean­ing.

Objective Approach to Ability to Pay:

Considering the practical difficulties associated with the subjective approach, some American economists developed an alternative ap­proach, based on objective factors consideration in the distribution of tax burden.

Prof. Seligman used the term ‘Faculty’ to indicate ability in the objective sense. Hence this theory is popularly known as ‘Faculty theory of Ability to Pay’. Taxes should be levied upon persons in proportion to their faculty or ability to pay and not in proportion to benefits received by them.

The basis of this approach is that people should help the state revenue in proportion to their power to help themselves. Persons who can earn large sums for themselves and so have ability to pay heavy taxes should be made subject to heavy taxation. Poorer classes who cannot earn much for themselves have comparatively less abil­ity to pay and so they should be taxed lightly.

Hence this approach considered faculty as a better criterion than benefit to impose taxes. Prof. Seligman expressed the view that money value of the taxable capacity of the taxpayer should be considered rather than his feel­ings and sufferings.

Index of Ability under Objective Approach:

The following index has been developed to measure the ability of a person to pay taxes:

(a) Property,

(b) Income,

(c) Consumption expen­diture, and

(d) Family circumstances.

In earlier societies, property was considered as the best index to measure the taxpaying capac­ity of a person. However, with the advent of the industrialized societ­ies, income began to be treated as the most objective criterion to measure the ability of a person. Recently, Kaldore and others sug­gest that, consumption expenditure should be taken as the real in­dex of a person financial status and to avoid tax evasion.

Mere in­come consideration will not hold good, since the size and composi­tion of family also exert influence upon the faculty of a person to pay taxes. Anyhow, objective approach gives a practical tool to analyses the distribution of tax burden in modern societies.