Notes on The Principle of Equity in Taxation

The Principle of Equity in Taxation – Explained!

The Principle of Equity in Taxation !

An important question widely discussed in public finance is what kind of tax system is fair, just or equitable. As seen above, equity in taxation was the first canon of taxation on which Adam Smith laid a good deal of stress. A fair tax system is not merely an issue in pure economic analysis but also in social philosophy. There are two prominent theories put forward to devise a fair or equitable tax system. They are (1) Benefits Received Theory and (2) Ability to pay Theory.

We discuss below these two theories of equity in taxation:

Benefits Received Theory (Quid pro quo):

According to this theory of taxation, citizens should be asked to pay taxes in proportion to the benefits they receive from the services rendered by the Government. This theory is based upon the assumption that there is an exchange relationship or quid pro quo between the tax payer and Government.

The Government confers some benefits on the tax payers by performing various services or providing them what are called social goods. In exchange for these benefits individuals pay taxes to the Government. Further, according to this theory, equity or fairness in taxation demands that an individual should be asked to pay a tax in proportion to the benefits he receives from the services rendered by the Government.

However, there are some difficulties in application of this theory. The most crucial problem faced by benefits received approach is that it is difficult to measure the benefits received by an individual from the services rendered by the Government.

For instance, how much benefit an individual tax payer derives from providing for national defence and education, and maintaining law and order by the Government cannot be measured with any objective criterion. Secondly, most of the Government expenditure is incurred on common indivisible benefits so that the division of benefits of Government expenditure is not possible.

Further, benefits received theory militates against the very notion of a tax. A tax is defined as a payment for general purposes of the State and not in return for a specific service. The benefit theory can have meaning if the benefits of the Government services to the community as a whole are considered.

But this will only indicate how much total tax revenue the community should pay to the Government. This will not help us in dividing the tax liability among various individuals comprising the community. It may be noted that most important common benefits are peaceful enjoyment of life, liberty and property.

So far as life and liberty are concerned, Government’s protection is the same for all. This will indicate levying of a toll tax. But toll tax has long been discarded as it was found to be highly regressive and also a small yielder of revenue.

The benefit principle is applicable only in cases where the beneficiaries can be clearly identified. Thus benefit principle is applied to the collection of road tax from vehicle owners. This is also applied when local bodies collect special levies for the services such as construction of sewers and roads they render to the people of their locality. The benefit principle is also applied to social security programmes for workers.

Social security contributions, or what are called payroll taxes, which are collected from workers are kept in reserves out of which benefit payments are made to them. To conclude, therefore, “at best the benefit principle can provide a partial solution to the problem of fairness in taxation.”

Ability to Pay Theory:

The ability to pay is another criterion of equity or fairness in taxation. This theory requires that individuals should be asked to pay taxes according to their ability to pay. The rich have greater ability to pay, therefore they should pay more tax to the Government than the poor.

Essentially, the ability to pay approach to fairness in taxation requires that burden of tax falling on the various persons should be the same. In the discussion of various characteristics of a good tax system, we mentioned about the two concepts of equity, namely horizontal equity and vertical equity based on the principle of ability to pay.

According to the concept of horizontal equity, equals should be treated equally, that is, persons with the same ability to pay should be made to bear the same amount of tax burden. According to the vertical equity, unequal’s should be treated unequally, that is, how the tax burden among people with different abilities to pay is divided.

In both these concepts of equity, what exactly do we mean by ability to pay and what are the objective measures of ability to pay are crucial. Some have explained the ability to pay treating it as a subjective concept. Others have treated the ability to pay in terms of some objective bases such as income, wealth, consumption expenditure etc. We shall explain below both these approaches to the measurement of ability to pay.

Ability to Pay: Subjective Approach:

In the subjective approach to tax paying ability, the concept of sacrifice undergone by a person in paying a tax occupies a crucial place. In paying a tax, a person feels a pinch or suffers from some disutility. This pinch or disutility felt by a tax payer is the sacrifice made by him. In this subjective approach to ability to pay, tax burden is measured in terms of sacrifice of utility made by the tax payers.

The following three principles of sacrifice have been put forward by various authors:

1. The Principle of Equal Absolute Sacrifice;

2. The Principle of Equal Proportional Sacrifice; and

3. The Principle of Equal Marginal Sacrifice (or Minimum Aggregate Sacrifice).

The principle of equal absolute sacrifice implies that the tax burden in terms of utility sacrificed should be the same for all tax payers. If U stands for total utility, Y stands for income and T for the amount of tax paid, then the principle of equal absolute sacrifice requires that U(Y) – U (Y – T) should be the same for all individuals.

The term U(Y) implies that total utility of a given income Y and U(Y – T) implies the total utility of the post-tax income (Y – T). If the equal absolute sacrifice principle is applied, none will be exempted from taxation and everybody will pay same amount of the tax.

Now, the pertinent question is what type of tax, propor­tional or progressive, follows from this principle. If marginal utility of money income falls, as is generally believed, and if this fall in marginal utility of money income equals the rate of increase in income, then this principle will suggests proportional income tax. However, if the fall in marginal utility of income is greater than the rate of increase in income, then equal absolute sacrifice principle will suggest progressive income tax.

Equal Proportional Sacrifice:

This principle requires that every person should be made to pay so much tax that the sacrifice of utility as a proportion of his income is the same for all tax payers. In terms of the notation used above, this implies that U(Y) -U(Y-T)/U(Y) of all tax payers should be equal. If a person enjoying higher income is to bear same proportion of sacrifice, then given the falling marginal utility of income, he will have to pay income tax at a higher rate. This means progressive income tax.

Equal Marginal Sacrifice:

According to this principle, tax burden should be so apportioned among various individuals that marginal sacrifice of utility of each person paying the tax should be the same. This approach seeks to minimize the aggregate sacrifice of the society as a whole.

When all persons pay so much tax that their marginal sacrifice of utility is the same, the loss of total utility by the society will be minimum. Thus, the principle of equal marginal sacrifice looks at the problem of dividing the tax burden from the point of view of welfare of the whole society. The social philosophy underlying this principle is that the total sacrifice imposed by taxation on the community ought to be minimum.

Assuming that marginal utility of income falls, the principle of equality of marginal sacrifice implies very high marginal rates of taxation. Indeed, in the extreme this principle can be used to recommend 100 per cent rate of tax on the people in highest income bracket in the society. Thus this principle recommends a highly progressive tax structure.

This principle of taxation has been recommended among others by Edgeworth, Pigou and Musgrave who consider this as the ultimate principle of taxation. It is worthwhile to quote Edgeworth, a chief exponent of this principle. “The minimum sacrifice is the sovereign principle of taxation.

If one is utilitarian and believes not only in the measurability of utility but also in the view that the law of diminishing utility is applicable to money also, then this principle would involve a high level of minimum exemption and a very steep pro­gression as income increases . The less the aggregate sacrifice, the better the distribution of tax burden in the community. The State exists to maximize human welfare. This it will be able to do by minimizing the sacrifices involved.”

Comments:

The whole subjective approach to ability to pay based on the sacrifice of utility has been termed as invalid because utility being a subjective entity cannot be measured in cardinal sense. Further, it is alleged there is no definite evidence that marginal utility of money income falls as income increases.

Interpersonal comparison of utility which the sacrifice approach requires is held to be unscientific. However, in the view of the present author, these objections against ability to pay or sacrifice principle are not valid. We may not be able to measure utility of money income in exact absolute terms but a sufficiently good measure of utility of income can be obtained and this is enough for the application of this principle of ability to pay in terms of sacrifice.

Observations in the world clearly indicate that people in the lower income brackets spend most of their incomes on buying necessaries, while people in the higher income groups spend a relatively greater proportion of their incomes on luxuries and non-essential goods. In view of this it is quite valid to assume diminishing marginal utility of money for purpose of taxation.

Ability to Pay: Objective Approach:

The objective approach to the ability to pay principle considers what should be objective base of taxation which measures ability to pay correctly. There is even no agreement on this question also. However, income is generally considered to be the best measure of ability to pay.

This is because a person’s income determines a person’s command over resources during a period to consume or to add to his wealth. However, it may be noted that ability to pay does not increase in direct proportion to money income.

Ability to pay increases more than propor­tionately to the amount of income. Justification of progressive income tax is based on this. Further, in order to ensure equity in taxing income distinction ought to be made between earned income and unearned income, and considerations should also be given for a number of depend­ents on the person paying the tax.

Wealth of a person is another objective measure of ability to pay that has been suggested as a tax base. The ownership of the property or wealth of an individual determines how much resources he has accumulated. Saving from every year’s income adds to his wealth. The wealth or property is therefore said to be a better index of taxable capacity.

It may however be noted that wealth alone is not considered to be adequate measure of taxable capacity and instead a combination of income and wealth taxes is regarded as a better measure from the viewpoint of ability to pay.

Thus, according to Prof. Kaldor, “Only a combi­nation of income and property taxes can give approximation to taxation in accordance with ability to pay”. Arguing the case for levying annual wealth tax in India, he writes “income taken by it is an inadequate yardstick of taxable capacity as between income from work and income from property, and also as between different property owners”. He further writes, “The ownership of property in the form of disposable assets endows the property-owner with a taxable capacity as such quite apart from the money income which that property yields.”

It follows form above that a combination of income tax and wealth tax will be a better measure of ability to pay.

Prof. Kaldor has also advocated another base for taxation. He has been a strong advocate of levying of expenditure tax in both the developed and developing countries. It should be noted that his expenditure tax is in fact a tax on consumption, that is, income minus saving. He claims that, it is consumption that is a fair or equitable base of taxation.

According to him, it is consumption that measures the resources that a person actually withdraws from the economy for his personal use. The part of his income not consumed, that is, savings lead to the increase in the capital stock and thus adds to society’s productive capacity. If a person consumes more than his income, he should the made to pay a higher tax because he reduces the capital stock of the country.

The imposition of expenditure tax, according to Kaldor, is particularly relevant for developing countries where high consumption expenditure of richer classes reduces the rate of capital accumulation. Imposition of expenditure tax will discourage consumption by taxing it heavily and promote savings by exempting it.

In 1958 on the recommendation of Kaldor expenditure tax was levied in India. But after some years it was withdrawn on the ground that it was difficult to administer it and also that the revenue from it was very small.

Conclusion:

In conclusion it may be said that it is better to levy taxes on various bases instead of a single base. As explained in the section of characteristics of a good tax system, diversity of tax bases is preferable not only from the viewpoint of a measure of ability to pay but also because-it will have less adverse economic effects.

Eckstein rightly points out, “Ex­cessive reliance on any one base may produce adverse economic effects because the rates may become too high. Therefore, a tax system may do less economic damage if it raises moderate amounts from several bases rather than larger amounts from one or two.”

Perhaps it is because of these reasons that in actual practice, a good variety of taxes are levied. In India, income tax, corporation tax, wealth tax and union excise duties are the most important taxes levied by the central Government, while sales tax, land revenue, and certain excise duties are the important taxes at the state level.