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Principles of Taxation

Principles of Taxation

What are taxes even for? And how is the decision made as to how much someone has to give in taxes? Some think it's a simple process where everyone gives a similar amount, whereas others think that taxes negatively affect a certain group of people disproportionately. Here, the main two principles of taxation are going to be introduced, as well as a comparison and a contrast, examples, and more. Keep reading on to learn more!

Principles of Taxation in Economics

What are the principles of taxation in economics? Let's start from the beginning.

Taxation is by far the most significant generator of revenue for the government. Taxpayers are obligated to make particular contributions, irrespective of their own preferences or wants. No tax is desirable, yet taxes are unavoidable if the government is to generate cash to cover its expenses. The government makes an effort to satisfy the majority of taxpayers by guaranteeing that taxes are sensible and fair. As far as the U.S. is concerned, there are two principles of taxation that taxes are based on - the benefit principle and the ability-to-pay principle.

The Two Principles of Taxation Defined

It's not an easy task to define the two principles of taxation. There are several strongly accepted notions regarding what constitutes a fair allocation of tax loads among taxpayers. The two main ones are: the benefit principle and the ability-to-pay principle.

The benefit principle holds that there should be some equivalency between what an individual ends up paying and the advantages they get as a result of government actions. The ability-to-pay principle is the view that taxes should be levied dependent on a person's means to pay.

The benefit principle is a principle of taxation that holds that there should be some equivalency between what an individual ends up paying and the advantages they get as a result of government actions.

The ability-to-pay principle is the view that taxes should be levied dependent on a person's means to pay.

The Two Principles of Taxation: Compared and Contrasted

The primary distinction between the two principles is what is getting taxed. The benefits principle taxes the benefits that someone gets from a public product or service, whereas the ability-to-pay method charges you based on your earnings. They both are similar in the sense that they're both attempting to make tax as "fair" as possible. Unfortunately, both principles have their shortcomings and that's what makes them similar. In their attempt to be fair, they are ironically seen as unfair in their own ways.

The benefit principle is seen as unfair because taxpayers who have lower incomes may actually end up paying more in taxes than those with higher incomes. This affects them disproportionately and would actually negatively impact the economy. And the ability-to-pay principle is seen as unfair because in many circumstances, just because someone has more money would mean that they would have to pay more in taxes. This would result in people paying for things or services that they don't even use!

Ability-to-Pay Principle of Taxation

The ability-to-pay taxation principle states that people with greater earnings should give a higher percentage of their income in taxes than those with lower earnings. The principle behind ability-to-pay taxation is that everybody should make an equal contribution when it comes to paying taxes, and because individuals with more wealth have less need for a dollar, giving more in taxes doesn't really inflict a bigger strain.

Essentially, think of it this way: if a millionaire gets a $15,000 raise in yearly salary, that will not make a significant difference to them. But for someone making $25,000, a $15,000 increase in yearly salary would make a great difference.

This principle is founded on two considerations. One, we can't always quantify the benefits of government expenditure. Two, it presumes that individuals with greater incomes are less bothered by paying taxes than those with lower incomes.

The ability-to-pay concept should be used to establish taxes if the government's goal is to redistribute money. Nevertheless, measuring ability is challenging. Overall, there are three kinds of ways to measure ability to pay: salary, spending, and property.

Salary

Income is seen to be a greater predictor of ability than wealth. However, some obstacles are experienced here as well. Not all jobs require the same level of hardship. A man earning $1,000 via hard labor will not be able to pay taxes in the same way as someone making the same money by betting or winning the lottery, for example. Also, someone with the same salary as another could have a greater number of dependents and obligations, resulting in a decreased ability to pay.

Spending

A poor guy might spend more because he has extra dependents and must care for his elderly parents. As a result, his spending could be greater than that of his coworker in the same salary bracket. However, his spending does not represent his genuine ability to pay.

Property

Ownership of riches or real estate reflects well-being, but only to a limited extent. For instance, even if two people have the same amount of funds, they aren't identically wealthy. One could have some productive wealth, such as an apartment complex that brings in a steady flow of money. Another person may have unproductive riches (such as designer handbags) of equal worth. Obviously, their capacity to pay taxes will be vastly different. If taxes are based on the premise of the ability to pay, individuals with more of an ability to pay, as determined by salary and/or wealth, will pay more in taxes.

Benefit Principle of Taxation

The idea behind the benefit principle is to try to make tax obligations as fair as possible. Paying a toll, for instance, charges someone based on how frequently they travel over a specific road or highway. A high level of usage for that road or highway results in a higher amount of money you end up paying. After all, every time you need to use that road you end up paying the toll. In the end, you spend more than someone who only uses that road or highway once in a blue moon.

However, there are people who don't see the benefit principle as being the fairest. But for what reason? It turns out that determining how much an individual benefits from a service can be close to impossible. Let's run through an example to see how this is true:

A good chunk of the money you give in taxes goes to support agriculture and food programs. This helps to sustain farmers all over the U.S.

The question becomes: Does an individual that earns $80,000 a year get twice the amount of benefits from agriculture and food programs as someone who earns $40,000? Pretend that they do. Now the question is: Since they benefit twice as much, should they pay twice as much in taxes that are allocated for the farmers?

Now let's flip this and ask: If the person earning $40,000 a year lives in a community that has many farms in it, should they pay more in taxes to support them? And how much should be paid?

Not exactly fair is it?

Determining the answers to these questions isn't straightforward and can become messy rather quickly. That's why some governments choose not to use the benefits principle and instead choose to use a different tax structure that would allow for at least a partial redistribution of wealth. Lower-income taxpayers might have a greater shot at bettering their financial status under that type of structure since less of their earnings would go toward taxes. This sort of approach also serves individuals who cannot afford to pay.

Examples of Two Principles of Taxation

Let's go through some examples of the two principles of taxation in turn: the ability-to-pay principle and the benefits principle.

Ability-to-Pay Principle of Taxation

An example of the ability-to-pay principle would be the income tax brackets. Tax rate increases are linked to the increasing incomes of people within their own tax brackets. Let's go through what that looks like.

If someone were to make less than $15,000 a year, for instance, their tax rate might be 10%. But for someone who earns between $15,000 and $50,000, their tax rate might be 12%. Someone earning more than $50,000 but less than $150,000 might pay 15%, and so on.

Benefits Principle of Taxation

An example of the benefits principle would be transportation system taxes.

Assume a low-income individual takes public transit to work considerably more frequently than a wealthier person. If the lower-income individual is required to pay more in taxes to sustain the public transportation system, they may end up not having adequate pay left over to cover anything other than the essentials like food and rent. This makes it far more challenging for them to have any savings or to better their financial status.

Rich people would be significantly less burdened by paying the same amount in taxes since they would still have enough money to support their lifestyle, put money away for emergencies, and make investments.

Two Principles of Taxation - Key takeaways

  • The benefit principle is a principle of taxation that holds that there should be some equivalency between what an individual ends up paying and the advantages they get as a result of government actions.
  • The ability-to-pay principle is the view that taxes should be levied dependent on a person's means to pay.
  • The primary distinction between the two principles is what is getting taxed.
  • An example of the benefits principle would be transportation system taxes.
  • There are three kinds of ways to measure ability: salary, spending, and property.

Frequently Asked Questions about Principles of Taxation

The Benefit Principle and the Ability-to-Pay Principle

They both seek to try to ensure as much fairness as they can with how they allocate the tax burden on different taxpayers.

There are two principles of taxation.

A tax bracket is a good example of an ability to pay principle of taxation

The benefit principle is a principle of taxation that holds that there should be some equivalency between what an individual ends up paying in tax and the advantages they get as a result of government actions. 

Final Principles of Taxation Quiz

Question

Taxation is by far the most significant generator of revenue for the government.

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Answer

True

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Question

There are two principles of taxation that taxes in the U.S. are based on: the benefit principle and the ability-to-pay principle.

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Answer

True 

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Question

What's the benefit principle?

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Answer

The benefit principle is a principle of taxation that holds that there should be some equivalency between what an individual ends up paying and the advantages they get as a result of government actions. 

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Question

What's the ability to pay principle?

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Answer

The ability-to-pay principle is the view that taxes should be levied dependent on a person's means to pay.

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Question

The primary distinction between the two types of taxes is what is getting taxed.


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Answer

True

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Question

The benefits principle taxes the benefits that someone gets from a public product or service, whereas the ability-to-pay method charges you based on your _______.


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Answer

earnings

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Question

How can the benefit principle be seen as unfair?

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Answer

It can be seen as unfair because taxpayers who have lower incomes may actually end up paying more in taxes than those with higher incomes.

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Question

How can the ability-to-pay principle be seen as unfair?

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Answer

It can be seen as unfair because in many circumstances, just because someone has more money would mean that they would have to pay more in tax. This would result in people paying for things or services that they don't even use.

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Question

Overall, there are three kinds of ways to measure ability to pay. What are they?


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Answer

Salary, spending, and property. 

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Question

The principle behind ability-to-pay taxation is that everybody should make an equal contribution when it comes to paying taxes, and because individuals with more wealth have less need for a dollar, giving more in taxes doesn't really inflict a bigger strain.


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Answer

True

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Question

Why can spending be a bad way to measure ability to pay?

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Answer

A poor person might spend more because they have extra dependents, for example. As a result, their spending could be greater than that of his coworker in the same salary bracket. However, their spending does not represent their genuine ability to pay.

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Question

Some governments choose not to use the benefits principle and instead choose to use a different tax structure that would allow for at least a partial __________ of wealth.


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Answer

redistribution

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Question

What's an example of ability-to-pay?

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Answer

Income tax brackets

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Question

What's an example of the benefits principle?

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Answer

An example of the benefits principle would be transportation system taxes.

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Question

What are the main points of the two principles of taxation?

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Answer

They both seek to try to ensure as much fairness as they can with how they allocate the tax burden on different taxpayers.

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