The Distribution of Tax Burdens

Updated Jun 26, 2020

There is no right answer when it comes to the distribution of tax burdens. That’s always a subject of heated debate. Although most people agree that taxes are necessary, disagreement usually arises over who should pay for them and how much. From these debates, two main principles have emerged on how to distribute the burden of a tax: (1) the benefits principle, and (2) the ability-to-pay-principle. We will look at both of them in more detail below.

1. The Benefits Principle

The benefits principle suggests that people should pay taxes based on the benefits they receive from the government. That means the people who use government services (e.g., police services, public infrastructure, justice system) the most should pay the most taxes, while those who benefit less should pay lower taxes. The idea behind this is that public goods should be treated more like private goods, which means that people should pay to consume them, but only if they actually do so.

To illustrate this, consider fuel taxes. Consumers have to pay a fuel tax of a few cents for every gallon of gas they buy. Much of the money raised by these taxes is used to build roads and improve transport infrastructure. Proponents of the benefits principle argue that this tax is fair because the people who buy gas are usually the ones who own a car. Therefore, they are also the ones who use the roads and benefit from better transport infrastructure.

2. The Ability-to-pay Principle

The ability-to-pay principle states that taxes should be levied on people according to how well they can carry the burden. That means people who can afford to pay more taxes (i.e., usually people who have more money) should be taxed higher than people can’t afford to pay as much. The idea behind this that the sacrifice taxpayers make should be equal, regardless of wealth and income. In essence, the ability-to-pay principle is based on two connected notions of equity: vertical equity, and horizontal equity.

2.1 Vertical Equity

Vertical equity refers to the idea that taxpayers with a greater ability to pay taxes should pay more. That means rich people should pay more taxes than poor people. While most people agree on that, the controversial part of the discussion is how much more they should pay. In response to this question, policymakers have developed three types of tax systems, i.e., proportional, progressive, and regressive tax systems. In a proportional tax system, the tax burden increases proportionally to the income. By contrast, in a progressive or regressive tax system, the tax burden rises at a faster rate or slower rate than the income, respectively.

To give an example, let’s look at federal income taxes. In the United States (like in most other countries around the globe), the government has introduced a progressive tax system. According to the IRS, for the tax year 2020, the federal income tax rates are as follows:

Because this is a progressive tax system, the tax rate increases as the income grows. That means the tax burden is heavier (relatively speaking) for people with a higher income. By contrast, if the tax rates were flipped the other way around, we’d be looking at a regressive tax system. And finally, if the rate were the same regardless of income, the system would be proportional.

2.2 Horizontal Equity

Horizontal equity describes the idea that taxpayers with similar abilities to pay taxes should pay the same amount. That means even if people have similar incomes, their individual circumstances (i.e., what they can afford to pay) should be taken into account when calculating their tax liabilities. That’s why we have tax deductions. In essence, tax deductions are a set of circumstances that are considered to be relevant for determining a person’s ability to pay (e.g., medical expenses, student loans, mortgage payments, charitable donations).

For example, consider student loans. Suppose two people both have an annual income of USD 50,000. However, one of them has a considerable student loan debt and has to pay USD 5,000 in interest every year for the next decade. That means, relatively speaking, this person cannot afford to pay as much as the person without the student loan, which is why there is a student loan interest tax deduction.

Please note, however, that horizontal equity only covers circumstances that are either beyond people’s control (e.g., medical expenses) or considered beneficial to society (e.g., student loans). In other words, people who are simply financially irresponsible have no right to tax deductions.

Summary

The distribution of tax burdens is always a subject of heated debate. From these debates, two fundamental principles have emerged on how to distribute the burden of a tax: the benefits principle, and the ability-to-pay-principle. The benefits principle suggests that people should pay taxes based on the benefits they receive from the government. By contrast, the ability-to-pay principle states that taxes should be levied on people according to how well they can carry the burden.