Taxable Capacity of a Nation: Meaning, Significance and Limits

After reading this article you will learn about:- 1. Meaning and Definitions of Taxable Capacity 2. Types of Taxable Capacity 3. Significance 4. Factors 5. Measurement and Limit.

Meaning and Definitions of Taxable Capacity:

Taxable capacity is a highly misleading and controversial concept in the theory of taxation. Different writers tried to define this concept differently. The definitions of the concept are not clear in respect of their implications.

In this context, Prof. Dalton observes “taxable capacity is a common phrase, but a dim and confused conception” whereas Prof. Shirras justifying the relevance of the concept, states that “it is always wise and useful for a government to know even roughly the limit that the country can contribute by way of taxation both in ordinary and extraordinary circumstances.

However, the ques­tion of taxable capacity is of importance in modern states, owing to mounting public expenditure and larger size of the budget.

In simple terms, taxable capacity refers to the capacity of a commu­nity or a nation to bear the burden of taxation. It is the capacity of the people as a whole and of different sections of the community to pay taxes, beyond which productive efforts began to suffer.

Prof. Findlay Shirras, an authority on public finance, writes “tax­able capacity is the limit of squeesability. It is the total surplus of production over the minimum consumption expenditure required to produce that level of production, the standard of living remaining un­changed”.

A somewhat similar definition is given by Taxation En­quiry Commission (1954). According to the commission report “tax­able capacity of different sections of the community may be said to refer to the degree of taxation, broadly speaking, beyond which pro­ductive efforts and efficiency as a whole begin to suffer”.

It implies that when taxation goes beyond the limit of taxable capacity, the efficiency will be adversely affected.

According to Sir Josiah Stamp, taxable capacity “means the ex­cess of aggregate production over the amount necessary to give a subsistence level of living to the people of the country. It means the societies income above this minimum amount”.

Another definition worth mentioning is given by L.H. Kimmel. According to him taxable capacity “is the capacity to raise revenue without extreme interfer­ence with productive activity and operation of the economy”.

Since all taxes affect income and wealth producing processes in one way or another, the emphasis is on extreme interference rather than on interference as such”. In this definition, Kimmel point to the adverse effect of large tax levies.

According to Prof. Musgrave, taxable capacity refers to the sac­rifice the community is able to sustain”. He also defined the concept of taxable capacity in a different context that arises in determining regional contribution to federal finance or the ‘fair’ contribution of various countries to an international organization”.

Musgrave also point out that the greater the per capita and group incomes, greater the ability to contribute.

Types of Taxable Capacity:

1. Absolute Taxable Capacity:

If refers to the maximum amount which can be collected from a community, without causing any unpleasant effects.

In other words, it constitutes the extent or limit up to which the state can impose taxes upon individuals or group of individuals. It is the maximum possible amount of tax that can be collected from the taxpayers.

According to Sir Josiah Stamp “absolute taxable capacity is the maximum amount which the citizen of a country can contribute to­wards the expenses of public authorities, without having a really unhappy and downtrodden existence and without dislocating the economic organization too much”. However, this definition lacks clar­ity, since there is no indication as to what is unhappy and downtrod­den existence.

Prof. Shirras says “it is the optimum taxability of a nation, the maximum amount of taxation that can be raised and spent to pro­duce the maximum economic welfare in that community”.

In this definition, there is confusion between the concepts optimum and maximum. In line with the principle of public finance, sometimes maximum taxation can exceed optimum taxation. Shirras also speaks of absolute taxable capacity as the limit of squeesability.

However, taxable capacity is not a constant concept. It is related to the vol­ume of public expenditure and other macro variables in an economy. The taxability of a nation is not a constant amount.

Overtime it will vary in accordance with variation in productive capacity, investment, economic growth, income distribution and volume of public expendi­ture expensed.

2. Relative Taxable Capacity:

Relative taxable capacity provides us a comprehensive analysis of taxable capacities of different taxpayers, groups of taxpayers or dif­ferent nations. In a sense, it refers to the taxable capacity of one community as compared to that of another community.

It also means the way in which burden of taxation should be distributed between different people in a community.

As Dalton points out “relative taxable capacity is the same thing as ability to pay. Relative taxable capacity is a reality, while absolute taxable capacity is a myth”. Absolute taxable capacity is a dim and confused concept and an illusion, according to Dalton.

He con­cludes that there is no way of ascertaining the absolute taxable capacity of a nation. However, both absolute and relative taxable capacity can be given intelligible meaning.

Suppose if ‘Yt’ stands for real income and ‘Emt’ for minimum consumption expenditure and T is the absolute taxable capacity or taxable capacity, then symbolically T = Yt – Emt.

Significance of Taxable Capacity:

Knowledge of taxable capacity is of immense use to the government and fiscal theorists for budget planning and resource mobilization. The knowledge of taxability of nation helps the government in differ­ent ways, under different circumstances.

The knowledge of taxable capacity is of immense use, during extraordinary situation like war. The idea on taxable capacity helps the government to know how much money can be collected from the people to finance extraordi­nary expenditure during war.

Similarly idea about taxable capacity helps the government in allocating tax burden rationally among dif­ferent sections of the community, especially between rich and poor. The knowledge of taxable capacity is useful for mobilizing economic resources needed for financing development projects like transport, irrigation, telecommunication etc.

Even in normal situation, the knowl­edge of taxable capacity is highly useful to meet unforeseen circum­stances like flood, earthquake etc., which necessitate the incurring of huge public expenditure.

Moreover, knowledge about the limit of taxable capacity prevents the government from imposing necessary taxes which will hamper productive system of the economy. Knowledge about the relative taxable capacity of different units in a federa­tion will help to reduce regional imbalance through central resource transfers.

It also helps to make a comparative analysis of the burden of taxation between different states in a federation. Lastly the con­cept of taxable capacity is of much use to the fiscal theorists and political process to critically analyze the financial relations between the center and units in a federation.

Factors Determining Taxable Capacity:

According to Prof. Shirras, taxable capacity of a nation depends upon the following factors.

(a) Size of National Income:

Taxable capacity of a nation is directly depended on its national income. Volume of national income depends on available resources and its proper utilization, quality of labour and technological skill.

Higher the national income, higher will be the taxable capacity and vice versa. Rich countries have larger capacity to pay tax than a poor country. Hence the taxable capacity of a nation is directly depended on national income.

(b) Size and Rate of Growth of Population:

Given the volume of income of a country, the taxable capacity is indirectly proportional to the size of its population. Larger the popu­lation, lower will be the taxable capacity and vice versa. Likewise, if growth rate of population is larger than the growth rate of national income, other things being the same, the per capital income will be lowered. Hence, the capacity to bear tax burden will be reduced.

(c) Distribution of Income:

Pattern of income distribution in a country determines the taxable capacity of the nation. The more unequal the distribution of income, greater is the taxable capacity. The major portion of tax revenue comes from the rich community.

It will be easy for the government to raise the major portion of tax revenue from richer sections of the community. Ability to pay taxes of the richer community is much greater than that of other sections of the community.

(d) Composition of Tax Structure:

Taxable capacity is closely related to the pattern of tax structure. By this we mean the method and character of taxation. A judicious combination of different taxes provides a stable and large volume of revenue. Likewise if there is a proper balance between direct and indirect taxes, the revenue productivity will be high.

(e) Stability of Income:

Taxable capacity is high, where there is stable income. If income fluctuates widely, taxable capacity becomes uncertain. In industri­ally developed countries, taxable capacity is high because income is high.

Where as in agrarian economies, where agricultural perfor­mance is linked with availability of monsoon, income is highly fluctu­ating. Hence, taxable capacity varies depending on the performance of agriculture and allied sectors.

(f) Character of Public Expenditure:

Tax revenue is used for many purposes by the government. If revenue collected by taxes is used for the creation and expansion of social and economic overheads like education, health service, Tele communication, transport system etc., it will enhance the productive effi­ciency of the economy.

As a result in the long-run production and income generation activities flourishes. This will eventually enhance taxable capacity of the people.

Likewise if public expenditure is channelized into economic development activities, production and income generation activities get stimulated and thereby taxable ca­pacity will be enhanced. On the other hand, if a major portion of public expenditure is expensed on unproductive investments, tax­able capacity will not increase.

(g) Psychology of Taxpayers:

During times of war and other emergencies, people would be willing to make greater sacrifice. People will be psychologically prepared to bear larger burden of tax in times of war and other national emergen­cies.

Likewise, if the people realize that government is properly uti­lizing the tax money for maximum benefit of the community, the people will be ready to bear additional burden of taxation. But if people feel that there is wide misuse of public money by government officials and it is spent unnecessarily, the psychology of the taxpay­ers will be never in favour of additional taxation.

(h) Standard of Living of the People:

Standard of living of the people depends upon consumption expendi­ture. Higher consumption expenditure means high standard of living. Higher consumption is possible by high income group. It means that only the higher income group can have a high standard of living.

Hence, people having a high standard of living will have a higher capacity to pay taxes and vice versa. That is why Prof. Kaldore suggested consumption expenditure as the best measure of a person’s tax paying capacity.

(i) Administrative Efficiency:

To a great extent, taxable capacity depends on the efficiency of the tax administrative system. If tax collecting machinery is efficient and tax obligations are uniformly enforced, tax evasion can be re­duced. This will enhance revenue collection and taxable capacity. Moreover, an efficient tax system helps to reduce cost of collection.

(j) Political Stability:

Political stability in a country is very important for creating a condu­cive atmosphere for healthy investment and productive activity. If the nation witnesses political instability, people will feel unsecured, in­vestments fly away and productive activities will come down.

Hence in an atmosphere of stability in administration, the security of the people will be very high and they will be ready to contribute larger taxes for the support of the government. If the country has a proper atmosphere for investment and productive activities, taxable capac­ity will be more than in a situation of uncertainty and instability.

(k) Economic Situation:

Taxable capacity is closely associated with the prevailing economic situation in the country. During periods of boom or economic pros­perity, taxable capacity will be high. During this period, income of the people will be high and profit margin will also be high.

Whereas during periods of depression, income and profit margin will decline fastly and hence taxable capacity will be low.

(I) Other Factors:

Apart from the above factors, the monetary and fiscal policies fol­lowed by the government also influence taxable capacity.

Moreover, the composition and nature of government, propensity to consume pattern of the people, saving investment and economic growth in an economy also influence the taxable capacity of a nation. Likewise, flow of foreign capital, emergence of favourable balance of payment, technological progress also helps to enhance taxable capacity of a nation.

Measurement and Limit of Taxable Capacity:

Several economists attempted to measure taxable capacity. Among these Prof. Colin Clark has made a realistic attempt to measure taxable capacity.

In his book “Welfare and Taxation” Colin Clark has argued that, for most countries of the world the maximum taxable capacity would be 25% of national income.

To quote his own words “the safe upper limit of taxation is 25% of national production”. Any level of taxation above 25% of income will result in highly unpleasant consequences for the country and for the people.

According to Clark, if taxation exceeds 25% of the safe limit, it may generate the follow­ing adverse consequences:

(i) A taxation above 25% will adversely affect the willingness to work and save and consequently reduce the level of national income.

(ii) A high level of taxation produce adverse effect on willingness to save and invest and will thereby retard capital formation.

(iii) High taxation affects all the agents of production. Insincerity and callous attitude develops in both employers and employees in the area of industrial production and other areas of productive

(iv) Workers faced with heavy taxation and rise in prices would fight for higher wages. This will further fanned the flames of inflation in the economy.

(v) Colin Clark believes that a high rate of taxation will have an adverse political affect also. Here Dalton’s conclusion on this aspect of taxable capacity is worth mentioning. He observes “it is impossible to fix any definite sum which could be said to represent the limits of the country’s taxable capacity at any particular time”.

The limit of taxable capacity is said to have reached, when due to excess burden of taxation, consumption is curtailed. Industrial production will be badly affected. Moreover, cost of collection will be high.

As a result additional taxation may not bring additional surplus revenue. Some fiscal theorists even argue that taxable capacity is reached when taxpayers are compelled to sell their securities to pay tax liabilities.