Taxes are the price we pay for civilization.
Oliver Wendell Holmes, Jr.
Taxes finance most of government spending. Many Americans complain about high taxes, but Figure 5 indicates that residents in most developed economies pay relatively more.
Who should pay how much of which taxes? Equity is a slippery concept, but precise terminology helps in analyzing fairness in taxation. Two somewhat contradictory principles broadly address equity in distributing tax burdens. The benefit principle favors taxes in accord with people’s benefits from government spending; the ability-to-pay principle advocates taxes in accord with one’s wealth or income.
The Benefit Principle
The benefit principle is an ancient doctrine that taxes should be in proportion to the benefits individuals receive from government.
The benefit principle of taxation taxes people in proportion to the marginal benefits they receive from a governmentally provided good.
This principle conforms to a universal gut feeling that you should pay for what you get. Revenues just adequate for optimal provision in our police patrol example can be secured by levying taxes so that people share costs in proportion to their marginal benefits.
Taxation according to marginal benefits is, unfortunately, impractical for most pure public goods. The public sector provides an incredible array of goods; collecting all the information required for appropriately different taxes is prohibitively costly. People cannot be excluded from enjoying the benefits whether they paid taxes or not. These characteristics of public goods lead to the free rider problem.
• Free Rider Problems
Suppose taxes were based strictly on your reported benefits from a public good. Some people might assert that they want little or none of it. Crafty types might even try to get tax credits by asserting that the good harms them. Once other people agree to buy a public good, free riders can enjoy it without cost.
The free rider problem arises when people evade paying for goods that are nonexclusive; they can use such goods without payment.
A few people might voluntarily contribute funds for a nonrival good from which exclusion was impossible. The erratic success of public TV is one example. More commonly, however, voluntary contributions would be insufficient for private firms to accommodate our collective demands for a nonexclusive good. There is little incentive to reveal your demands for safer highways, cleaner air, better schools, or cancer research if you will be taxed accordingly. Why not be a free rider? Widespread free riding may preclude some public goods. Private firms could not adequately market them, so government provides most public goods and forces us to pay for them through taxes.
• User Charges
General tax revenues are used to pay for most goods government provides, but the benefit approach to funding public goods is a basis for user charges that relate taxes to expected benefits. When a governmentally provided good has the exclusive characteristics of a private good, benefits can be approximated, with users being charged the costs of service. Examples include bus fares and entry fees for public museums, zoos, parks, or toll roads. Gasoline taxes are also roughly proportional to benefits; owners of heavy trucks or drivers of huge gas hogs pay more gas taxes than do drivers of fuel-efficient compact cars, but they also put more wear and tear on the highways that gasoline taxes support.
Although the benefit principle of taxation is often inapplicable because individuals’ preferences for public goods are concealed, general tax revenues are often used to fund activities where user charges could easily be applied. For example, should vegetarians pay for meat inspections? User charges imposed on meat-packers would be shifted forward to meat buyers. Similarly, federal tests of new medicines could be billed to the pharmaceutical companies that want to market them. If airports, air traffic controllers, and airplane safety inspectors were paid for exclusively by carriers, these tax burdens would not be borne by people who benefit little from air transport.
Political and practical difficulties, however, are not the only drawbacks of benefit taxes. Benefit taxation may conflict with other types of concerns about equity.
The Ability-to-Pay Principle
An alternative to the benefit principle of taxation is the idea that taxes should be proportional to one’s ability to pay.
The ability-to-pay principle suggests that the fairest tax is one based on your financial ability to support government activities.
Taxes can be related to income in three basic ways:
1. A tax is progressive if higher incomes are taxed proportionally more than lower incomes.
2. Proportional taxes are a fixed percentage of income.
3. A tax is regressive if the percentage of income paid as taxes falls as income rises.
The benefit and ability-to-pay principles, though seemingly inconsistent, may lead to similar policies. Rich people may benefit more than the poor from such public goods as national defense or police and fire protection because rich people stand to lose more from disasters. They drive more miles on public roads and ring up more frequent flyer bonuses when flying out of publicly supported airports. Thus, both the benefit and the ability-to-pay principles may support the rich paying more taxes than the poor.
• Vertical Equity Vertical equity is the idea that a rich person should pay more taxes than a poor one for each to bear the same burden in supporting government.
Vertical equity asserts that people better able to pay higher taxes should do so.
Implementing vertical equity in any tax system involves deciding who should pay higher rates and then writing tax laws that actually collect this amount from the correct people. Wealth and income are normally viewed as good measures of one’s ability to pay taxes. Progressive taxation is, however, unnecessary for vertical equity; even regressive tax systems might satisfy this equity principle as long as the rich paid more in absolute terms.
• Horizontal Equity The Fourteenth Amend- ment to our Constitution (the Equal Protection clause) states, “nor shall any State deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdiction the equal protection of the laws.” This concept that equals must be treated equally is now known as horizontal equity.
Horizontal equity requires that individuals who are equal in all important respects be treated equally.
Implementing a horizontally equitable tax system first requires identifying what constitutes equal circumstances—income, wealth, age, or marital status? Then we must specify what equal treatment means. Does equal treatment mean equal tax rates or equal tax payments over a lifetime?
Equity in our tax system requires both horizontal and vertical equity. Horizontal equity dictates that equals should pay equal taxes; vertical equity means that unequals should be treated unequally. Vertical equity is at the heart of the ability-to-pay principle.