This article throws light upon the three main principles for equitable distribution of tax burden. The principles are: 1. The Cost of Service Principle 2. The Benefit Principle 3. Ability to Pay Theory.
1. The Cost of Service Principle:
This principle suggest that the cost incurred by the government in providing public goods to satisfy social wants should be regarded as the basis of taxation. The expenses of government should be apportioned among the people according to the costs incurred in rendering a particular service to the people.
The chief exponent of this principle was the Austrian economist Von Hock. The state is just like a producer of social goods and taxes are the prices for the same.
Von Hock considered the services provided by the state, falling in three categories. Firstly, there are certain services of the state which confer uniform benefit to all. For example, defence, law and order, maintenance of public health etc. These services are provided to rich and poor alike.
These should be made the basis of a personal tax. Secondly those who possess property and own industry get certain additional benefit under the protection of the state. Further the owners of property benefit by appreciation in the value of their property.
Protection of business and possession of property involve some cost, which should be recovered through a property tax.
Thirdly there are certain special services such as education, building of highways, the recording of mortgages etc. rendered to particular individuals who get a direct benefit out of these. Since these services are of special character, they should be made the basis of a special payment, according to cost of service approach.
This notion was prevalent in medieval times when everything was regarded as a payment for service rendered-justice, defence, administration etc. Hence the cost of service principle to taxation was applicable only to a feudal regime, where feudal payments were considered as the legitimate dues of the sovereign in return for the service of protection provided by them.
This principle has many shortcomings. It is not easy to estimate the cost of government service or social goods made available to each individual taxpayer. It is difficult to find out any precise measurement of the costs and sharing of such costs in most of the indivisible public service such as defence, police etc.
This principle is not In conformity with the definition of tax. A tax is not a price; tax has no quid-pro-quo.
It imposes undesirable limitation on the scope and scale of the public services. According to this principle, only those public services are justified for which the public is capable of bearing the cost.
Hence, in effect this theory does not justify many social welfare programmes of the government such as the relief works during famine or floods, free general education, free medical facilities to the poor etc. the beneficiaries of these welfare measures are the poor who cannot bear the cost of providing the same.
It goes against the norms of welfare economics. If cost is the base of taxation, government cannot provide free education and medical care to the poor sections of community.
2. The Benefit Principle:
According to this approach dating back to Adam Smith and earlier writers an equitable tax system is one under which each taxpayer contributes in line with the benefits which he receives from public services.
The persons receiving equal benefits from the state should pay equal amount as taxes. Those who receive greater benefits should pay more as taxes. The benefit principle is very much similar to the cost of service principle.
The former approaches the problem from the side of the demand while the latter looks at it from the side of supply.
The benefit approach to taxation was accepted widely among the political theorists of the 17th century. Its modern formulation dates back to Adam Smith and leads up to Voluntary Exchange Theory of Lindahl.
(i) The Classical Version:
The mercantilist writer, Sir William Petty argues that “it is generally allowed by all that men should contribute to the public charge, but according to the share and interest they have in the public peace that is according to their estates and riches”.
In the first sentence of his Maxim Smith introduced ability as well as benefit considerations in revenue rising. Smith observes “the subjects of every state ought to contribute towards the support of the government as nearly as possible in proportion to the revenue which they respectively enjoy under the protection of the state”.
This raises some doubt whether Smith should be placed in the benefit camp. But towards the end of book No. V of Wealth of Nations there appears a clear cut rule that the cost of public expenditure should be allocated according to benefit and that general contribution should be used only where expenditure cannot be allocated on a benefit basis.
According to Smith, everyone is benefited from public services and everyone should contribute to the cost of sustaining them. But the problem is how we can measure individual benefit and cost.
Since there is no practical way of doing this, a general rule of thumb is needed in place of individual imputation. This rule, according to Adam Smith, is provided by taxing individuals “in proportion to their respective abilities”. That is the revenue which they respectively enjoy under the protection of the state. Musgrave argues that Smith shrewdly inserted an ability element into the weak link of the benefit rule.
A renaissance of the benefit approach took place in the hands of Pantaleoni, Mazzola and de Viti de Marco in Italy and Sax in Austria. They joined in an effort to integrate the determination of taxes and expenditures with the allocation of resources in the market. Taxes came to be viewed as a price for public service in line with taxpayer demand.
The determination of the tax price in accordance with benefit received came to be looked upon as a condition of efficient allocation. Beyond this, it was regarded as a condition of equilibrium brought about by either a political or a market process.
Mazzola an Italian economist argues pricing of public services is entirely different from pricing of private services. Public services are equally consumed by all. Since the utility schedule for public services are different for different individuals, charging a single price for public services is not an efficient solution.
Hence for attaining equality between tax and marginal benefits, public service has to be supplied to individuals at different price, irrespective of the fact that they are consumed in equal amount by all.
The inference is that tax payment will be different for different individuals in accordance with the marginal benefit, which they expect from a particular quantity of public service.
Wicksell’s justification is that benefit theory of taxation is just, because it is in conformity with democratic spirit of individual freedom. Wicksell argues that since taxes are paid in accordance with the benefit received, no question of unjust compulsion of contribution to public services arises.
The Italian economist de Viti de Marco in 1888, advocated that “citizens duty to pay taxes should be matched by the states duty to supply public services”.
He advocates that every individual is a consumer of public services. As such income of the consumer reflects the index of demand for public service. Accordingly rich, person’s capacity to pay for public service is comparatively higher than a poor person, even though both receive the same amount of public service.
He tried to introduce an element of progressive taxation in the benefit theory. When each citizen uses public service in proportion to his income, he concludes that taxation should be progressive.
(ii) Modern Views on Benefit Theory – Voluntary Exchange Approach:
(a) Lindahl Solution:
A modern approach to the benefit view of taxation comes from the famous Swedish economist Erik Lindahl in his voluntary exchange theory in 1919.
In its simplest form, the theory states that the cost of supplying public service should be covered by taxes voluntarily contributed by the beneficiaries, just as they pay voluntarily for any commodity purchased from private market.
Lindahl’s theory simultaneously tries to find out solution to allocation and distributive aspect of fiscal problem.
Lindahl’s soh lion involves taking three set of decisions simultaneously. They are
(a) We must determine the total amount of public expenditure to be incurred and tax resources raised,
(b) The second decision relate to the allocation of total public expenditure among goods and services meant for the satisfaction of social wants and
(c) The allocation of total taxes among various individuals, who are beneficiaries of the provision of public service.
Lindahl states that these decisions are included in the allocation branch and are mutually interdependent and it must be rendered jointly. In a sense Lindahl applies the marshallian market principle of total cost allocation of two joint products to their respective supply prices.
Lindahl’s solution can be explained with the following numerical example. Let us consider a community consisting of two tax payers ‘A’ and ‘B’ and one type of social goods. Both ‘A’ and ‘B’ consumes the total amount of social goods supplied. But they receives different amount of satisfaction from it.
Hence their benefit share may be considered as joint products. So cost of supplying social good is jointly contributed by A and B. Individually one will have to pay less as the other contributes more
The only way to allocate cost is to do it in accordance with the demand for two products. Thus if A’ is willing to contribute ‘X’ percent of the total joint cost, then ‘B’ will be contributing the rest, that is (1 – X) percent of the total cost.
Thus joint contribution of both A and B covers the total cost of supplying the social good. It follows that A’s offer to contribute certain percentage of total cost may be looked upon as ‘B’s supply schedule of goods. Likewise ‘B’s offer may be similarly seen as the supply schedule for ‘A’.
Quantities of social goods are measured along the horizontal axis. Percentage of total cost contributed by A’ along left vertical axis and percentage of total cost contributed by ‘B’ along right vertical axis.
Total unit cost of supplying social good is OV. The curve ‘aa’ is the demand schedule of individual A’ and ‘bb’ corresponds to that of ‘B’. Taxpayer A’ will be willing to contribute 100 percent of cost for output OE, which will then be available free to ‘B’. At the output level OG, taxpayer A’ is willing to contribute GS percent of the cost.
Then the output is available to taxpayer ‘B’ at PS percent of cost. But taxpayer ‘B’ willing to contribute ‘PR’ percent of cost, because ‘R’ is the point on his demand schedule. Hence the total contribution of taxpayers ‘A’ and ‘B’ will exceed the cost of supplying social well by SR percent. This indicates that both taxpayers A and B prefer larger scale of social goods.
The optimum level of social good is given at OF, at which taxpayer ‘A’ contributes FQ percent of cost and taxpayer ‘B’ contributes TQ percent of cost. Their combined contribution covers the total cost of supplying OF level of social good.
It is not possible to extent the production of social good beyond the quality OF. The reason is that the combined contribution of both taxpayers will fall short of total cost of production.
Let us take the point OW level of output. At this output level, taxpayer ‘A’ will be willing to contribute WX percent of cost and taxpayer ‘B’ will be willing to contribute MN percent of cost, because ‘N’ is the point on his demand schedule. As a result ‘NX’ percent of cost will remain uncovered.
Suppose now taxpayer ‘A’ contributes ‘WD’ percent of cost, then ‘OW’ quantity of social good can be produced and supplied. But the taxpayers will be paying larger share of cost than the valuation they attach to the social good.
Hence both tax payers ‘A’ and ‘B’ will vote for small quantity of social good. Similarly it can be shown that both the taxpayers will reveal their preference for larger quantity of social goods, when the supply of social goods falls short of the optimum level at OF.
In this way, the budgetary process for the satisfaction of social wants is determined by a competitive solution, as in the case of a private goods market. Thus the voluntary exchange model of the benefit approach provides a tool by which the quantity of public goods and the contribution of tax share might be simultaneously determined.
(b) Bowens Solution:
A better and simple model of benefit principle has been presented by Howard. R. Bowen in his book “Towards Social Economy” published in 1948. Prof. Musgrave favours Bowens approach, because it is more realistic and assumes increasing cost conditions in the provision of social goods.
Bowen’s simple model is explained by assuming one social good and two individual tax payers ‘A’ and ‘B’. The figure 4.2 illustrates the model.
Here we have one social good and tax payers ‘A’ and ‘B’. The demand of taxpayer consumers A’ and ‘B’, respectively for social good are presented by ‘a’ and ‘b’. The total demand for social good is given by the schedule (a + b).
The supply curve of social good is represented by ‘S’. It is upward rising, which indicates that social good is produced under conditions of increasing cost. OX axis represent quality of social good and OY axis the price of social goods or tax to be paid by beneficiaries to meet the cost of social good.
The above figure simultaneously determines the amount of social goods and the tax share between consumers according to their own valuation of benefits.
The equilibrium quantity of social good is OE, and the total amount of tax revenue to be raised to cover the cost of supplying OE quantity is given by the area OEBA. ED and EC are the marginal benefits expected from OE quantity of social good, by tax paying consumers A and B respectively.
Hence A’ will pay ‘ED’ and ‘B’ will pay ‘EC’ amount of tax per unit, so that the total amount of tax revenue raised comes to OEBA. The tax share of A and B will be OEDF and OECG respectively (OEDF + OECG = OEBA).
Any quantity of social good other than OE level will not be an optimum level of supply. For example, if the public good is at OH output level, the combined contribution of tax per unit will be HK, which is larger than the cost of supplying it that is HJ.
It reveals that more social good is demanded. At OL quantity of social good, the total contribution LM, per unit falls short of its cost, that is LN. Hence OE provides the optimum mix of social goods.
An Assessment of the Benefit Approach:
The benefit approach to tax burden distribution has some advantages. It co-ordinates the revenue and expenditure sides of the budget directly. It involves an approximation of market behavior in the Allocative procedure of the public sector.
Allocative efficiency and distributional equity considerations are reconciled in this approach. The theory suggests that the benefit conferred by public services justify the imposition of taxes to pay for them. This theory is essentially a cost benefit approach which maintains a balance between income and expenditure of the government.
Moreover the theory links the provision of public services to the preference pattern of individuals. However this approach, though simple in application, has little practical use due to a number of limitations.
The theory is based on an unrealistic assumption that varied and complex activities of the public authorities are calculable and measurable.
According to this theory this can be assessed on the basis of personal benefit received. But in reality benefits from public services are indivisible. Moreover there is no standard yardstick to measure benefit conferred upon the people. How can we measure and divide the benefits of national defence or education which give rise to externalities.
The benefit approach limits the scope of government activities. Modern state is a welfare state. It provides certain services meant for the common benefit of the society and mostly targeted for the poorer sections of the community.
In this case, there is no quid-pro-quo basis in the exchange of social goods. Hence if this theory is truly followed, government will have to stop many of its welfare oriented expenditure policies targeted towards the socially vulnerable groups in the society. In this sense the theory seems obsolete.
The Lindahls’ solution to benefit approach, assumes optimum distribution of income. However no precise meaning is given as to what constitute an optimum distribution of income.
At its core the theory assumes that each consumer reveals his preference for social goods. However in reality consumers cannot reveal their preferences because of ignorance or with deliberate intension. Hence authorities cannot judge and take prudent Allocative decisions.
Hence it can be concluded that benefit approach to distribution of tax burden has little operational significance. It is theoretically sound, and is an ideal approach, but lacks of practical applicability.
In practice, state cannot allocate tax burden on the basis of benefit conferred. Many of the budgetary operations of the state are beyond the lines of pure cost-benefit approach. However, it has some limited application, in the case of local authorities.
Local authorities if needed can apply some local taxes on benefit-cost basis. For example, limited application of this principle, in certain taxes such as vehicle tax, for financing improvements in road system is admitable and feasible.
3. Ability to Pay Theory:
The ability to pay approach or the faculty theory of taxation has been regarded as the ideal principle for the apportionment of tax burden. The principle of distribution of tax burden, which is in conformity with the popularly accepted notion of equity, is that of ability to pay.
By ability in the common parlance, we mean economic well-being or the overall level of living enjoyed by the tax payer. This principle fundamentally means that persons who have the same ability to pay should pay equal amounts of taxes and that the persons who have greater ability should pay more to the government, than those who are less well-off.
Those lacking any ability should be exempted from shouldering tax burden. Thus ability to pay theory was considered as the just and equitable theory of distribution.
According to J.S. Mill “equality in taxation means equality of sacrifice”. Adam Smith, the chief exponent of ability to pay theory states “the subjects of every state ought to contribute towards the support of the government as nearly as possible, in proportion to their respective abilities, i.e. in proportion to the revenue which they respectively enjoying under the protection of the state”. Musgrave states that “ability is the ideal, ethical basis of taxation”.
Taxation according to ability to pay involves the realization of both horizontal equity and vertical equity. Horizontal equity is the concept that individuals with identical abilities to pay should be assigned identical tax burdens.
The basis of the concept of vertical equity is that tax burden should rise with ability to pay. That is people with greater ability should pay more as tax, to shoulder the cost.
(i) Measurement of Ability to Pay:
It is very difficult to frame an ethical base to judge the ability of a person to pay taxes. An analysis of the concept of ability, involves framing the necessary conditions and qualification which must be observed in setting up the standard of ability, as the proper foundation of modern tax system.
Different interpretations have been given to the term ‘ability to pay’. Basically there are two approaches – namely the subjective approach and objective approach to measure ability to pay. In the subjective approach, the sacrifice theory has been developed and in the objective approach, the faculty theory has been developed.
(ii) Index of Ability to Pay:
The earlier economist considered property as the best index of a person’s ability to pay. In earlier agrarian societies, the economic wellbeing of a person depends upon the property possessed by them.
Hence income from property was considered as the suitable index of a person’s ability to pay taxes. However, property as an index possesses a number of limitations in determining the ability of a person to pay taxes.
Firstly all kinds of property are not capable of generating income. Income from property is not a continuous flow. Depending upon location, climatic conditions, geography, and fertility etc. income from property varies considerably.
With the advent of industrialization and emergence of industrial society, there occurred a shift in emphasis to income from property as the suitable index. The net income concept was considered as the best index to calculate tax paying capacity of a person. Adam Smith observed that income is the best measure of the index of ability to pay. Taxable income was considered as income above subsistence.
(c) Size of Family:
In the modern world, size and composition of family influence and determine tax paying ability of a household. A large size of family with a fixed income, possess little tax paying capacity than a small family with the same level of income.
Given the same income, a bachelor has high tax paying capacity than a household with five members.
However, size and composition of family cannot be taken as the primary measure of tax paying ability. But along with income, size of family also should be given due weightage in asserting the taxable capacity of a person.
Consumption expenditure is also a good index of ability to pay taxes. An individual can evade taxes imposed to the basis of his income, by fraudulent practices. He can furnish false information regarding his earnings and evade payment of taxes.
Hence professors J.S. Mill, Irving Fischer and Kaldor, advocate the consumption expenditure as an index of taxable capacity. To quote Kaldor “consumption rather than income should be the basis of taxation”.
Consumption reveals the resources that an individual actually withdraws from the economy for his personal use. Hence, consumption expenditure was suggested as the suitable criterion to ascertain the taxable capacity of a person.