Ability to Pay

What Is Ability to Pay?

Ability to pay is an economic principle that states that the amount of tax an individual pays should be dependent on the level of burden the tax will create relative to the wealth of the individual. The ability to pay principle suggests that the real amount of tax paid is not the only factor that has to be considered and that other issues such as the ability to pay should also be factored into a tax system.

Understanding Ability to Pay

The application of this principle gives rise to the progressive tax system, a system of taxation in which individuals with higher incomes are asked to pay more tax than individuals with lower incomes. The ideology behind this principle is that individuals and business entities that earn higher income can afford to pay more in taxes than lower-income earners. Ability to pay is not the same as straight income brackets. Rather, it extends beyond brackets in determining whether an individual taxpayer can pay his or her entire tax burden or not. For instance, individuals should not be taxed on transactions in which they don’t receive any cash. Using stock options as an example, these securities have value for the employee who receives them and are, thus, subject to taxation. However, since the employee does not receive any cash, s/he would not pay tax on the options until s/he cashes them in.

Advocates of ability-to-pay taxation argue that it allows those with the most resources the ability to pool together the fund required to provide services needed by many. Critics of this system believe that the practice discourages economic success since it burdens wealthier individuals with a disproportionate amount of taxation. Classical economists like Adam Smith believed any elements of socialism, such as a progressive tax, would destroy the initiative of the population within a free market economy. However, many countries have blended capitalism and socialism with a great degree of success.

In banking, ability to pay is called “capacity.” It is used by lending institutions to determine a borrower’s ability to make his interest and principal repayments on a loan, using his or her disposable income or cash flow. Some bankers judge a borrower’s capacity using the standard Five C’s of Credit – credit history, capital base, capacity to generate cash flow, collateral, and current conditions in the economy. For municipal debt issuers, ability to pay refers to the issuer’s or lender’s present and future ability to create sufficient tax revenue to fulfill its contractual obligations.