Ability-to-Pay Taxation: Definition and Examples

What Is Ability-To-Pay Taxation?

The ability-to-pay philosophy of taxation maintains that taxes should be levied according to a taxpayer's ability to pay. Underlying this is the idea is that people, businesses, and corporations with higher incomes can and should pay more in taxes. The ability-to-pay principle is also known as progressive taxation.

Understanding the Ability-To-Pay Principle

Ability-to-pay taxation argues that those who earn higher incomes should pay a greater percentage of those incomes in taxes compared with those who earn less. For example, in 2023 individuals in the United States with taxable income less than $11,000 faced a 10% income tax rate, while those with taxable income of more than $578,126 faced a rate of 37%, the nation's top individual rate. Earnings between those amounts face tax rates as set by income brackets.

The idea underlying ability-to-pay taxation is that everyone should make an equal sacrifice in paying taxes, and because people with more money effectively have less use for a given dollar, paying more of them in taxes does not impose a greater burden. Think of it this way: To a person with earns $1 million a year, $10,000 will make very little difference in their life, while it will make a big difference to a person earning only $60,000 a year.

History of Ability-to-Pay Taxation

The idea of a progressive income tax—that is, that people with the ability to pay more should pay a higher percentage of their income—is centuries old. In fact, it was once espoused by none other than Adam Smith himself, considered the father of economics, in 1776.

Smith wrote: “The subjects of every state ought to contribute toward the support of the government, as near as possible, in proportion to their respective abilities; that is in proportion to the revenue which they respectively enjoy under the protection of the state.”

Ability-to-Pay Pros and Cons

Arguments for Progressive Taxation

Advocates of ability-to-pay taxation argue that those who have benefitted most from the nation’s way of life in the form of higher incomes and greater wealth can afford and should be obligated to give back a little more to keep the system running.

The argument is that the society that government tax revenue has helped build—infrastructure such as highways, fiberoptic communications networks, a strong military, public schools, a free market system—provide the environment in which their success was made possible and in which they can continue to enjoy success.

Criticism of Ability-to-Pay Taxation

Critics of progressive taxation argue that it is fundamentally unfair. They say it penalizes hard work and success, and it reduces the incentive to make more money. Many argue that everyone should pay the same income-tax rate—also known as a "flat tax"—to make the system more equitable.

Progressive Taxation and Inequality

While the U.S. still maintains a progressive tax system, tax rates for the rich have plummeted over the past several decades. When President Ronald Reagan took office in 1981, the highest income tax bracket for individuals was 70%. In 2020, the top rate for incomes is 37%. Meanwhile, inequality has reached levels not seen in at least a century. The top 1% now holds more wealth than the bottom 90%.

The Bottom Line

Ability-to-pay refers to a principle holding that taxes should be levied according to one's ability to pay them. Naturally, this would mean that higher earners and wealthier individuals would pay higher tax rates than those with lower or middle income. A tax system structured as such is also known as progressive taxation, and it has both proponents and detractors.