What is 'Ability-To-Pay Taxation'

Ability-to-pay taxation is a progressive taxation principle that maintains that taxes should be levied according to a taxpayer's ability to pay. This progressive taxation approach places an increased tax burden on individuals, partnerships, companies, corporations, trusts, and certain estates with higher incomes. 

The ability-to-pay taxation theory is that individuals who earn more money can afford to pay more in taxes.

BREAKING DOWN 'Ability-To-Pay Taxation'

Ability-to-pay taxation requires higher-earning individuals to pay a greater percentage of their income towards taxes, compared to individuals with lower incomes. The tax rate increases as a percentage along with income. For example, as of 2018 for individuals in the United States, taxable income up to $9,525 incurs a 10% income tax, while earnings over $500,000 face a 37% income tax rate. Earnings between those amounts face tax rates as set by income brackets.

Pros and Cons of Ability-to-Pay Taxation

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. People and businesses rely on these services, either indirectly or directly, such as snow removal, schools, scientific research, police, and libraries. 

Additionally, using ability-to-pay taxation has the potential to increase a government's revenues. Arguably, if a government uses a flat tax instead of the ability-to-pay taxation, it must use relatively low tax rates to accommodate low-wage earners. Following the theory of deadweight loss of taxation, if the same rate applies to everyone, it will cause a loss of revenue due to a lack of fund remaining after paying taxes. Also, as low-wage earners are more likely to need all their earnings, allowing them to keep a larger percentage of it helps to stimulate the economy.

Critics of ability-to-pay taxation state that progressive tax systems reduce the incentive to climb the earnings ladder. It penalizes those who through hard work and ingenuity have risen into higher incomes. These critics claim ability-to-pay taxation is not fair for wealthy individuals.

Other critics prefer a benefit-received taxation method. Rather than basing taxes on what an individual can afford to pay, benefit-received taxation levies taxes on the people who receive the benefits of the tax. For example, the government earmarks taxes collected from gasoline sales for roads. Essentially, when drivers pay tax on gasoline, they receive the benefit of well-maintained roads. Conversely, people who don't drive also don't have to buy gas and do not end up paying that tax.

How the Internal Revenue Service Determines Ability-to-Pay

The phrase "ability to pay" refers to a taxation principle which supports progressive taxation systems. It does not necessarily ensure that an individual can afford their taxes, as affordability can be subjective. However, lawmakers work on modifying the tax code or revising deductions and credits to make taxes more affordable.

If an individual owes back taxes to the Internal Revenue Service (IRS), they may apply for a payment plan or a reduced payment. At that point, the IRS looks at their ability to pay. Based on their personal finances and assets, it decides whether to accept the payment plan.

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