Definition: Ability to pay is the relationship between the amount of money an individual earns and the amount of tax he or she will owe upon that income. Ability to pay is, therefore, not only a tax concept but also an economic one
Ability to pay is one of four key factors economic policymakers use to determine who should pay higher taxes. The other three factors are an individual’s earning capacity, assets, and liabilities (such as a change in market value held by a non-residence individual versus fixed assets held by a resident individual).
Ability to pay is the amount of money an individual can pay federal and state taxes each year without incurring a recharacterization penalty without exceeding credit limits. The more this number is positive, the better the individual’s tax situation is perceived by the Internal Revenue Service (IRS). In other words, the more able to pay an individual has, the better their prospects for avoiding a large tax bill.
Understanding Ability to Pay
A progressive tax system gives the government the ability to tax citizens and businesses at different rates based on their income. This principle is often used to explain why lower-income people pay more in income taxes than higher-income people.
For Example, if a person makes $10,000 per year and has a $2,000 inheritance, they would pay an extra $2,000 in taxes. The government can then use this extra revenue to help lower-income people pay the bills or provide health insurance for seniors who need it more expensive than other individuals. The system is progressive because it groups different individuals and businesses into different groups based on their incomes.
Ability to pay is often measured by debt-to-income ratios—the number of times an individual must make a payment for his income to be in balance. This ratio is commonly expressed as a percent.
For Example, if an individual has a zero percent debt-to-income ratio, their income covers their monthly bills and debts. If the ratio is 100, the individual must make 100 payments to earn one dollar. 101 means an individual has paid off their debt.
Calculation of Ability to Pay
There are many different ways to calculate the ability to pay. For Example, the government may calculate it for you using the debt-to-income method if you are married and filing a joint return, or if you have any outstanding tax debt, or if you are pursuing education or training to greater than the 12th-grade level, or if you are enrolled in a welfare program.
Taxpayers with more resources can afford to pay for social services more efficiently, thus reducing the burden on those with fewer resources. Such advocates are correct if their goal is to reduce the overall level of taxation–as it should be–but they fail to recognize that efficiency can also be achieved at the individual level by pursuing the right kind of education and training.
Ability to pay is important because it is one of many factors used by banks to determine how much money you can borrow. For Example, a borrower with good capacity might be given lower interest rates and a shorter grace period on their loans. The interest rate is the rate at which the lender pays on unpaid debts.
The grace period could be several months or years, depending on the type of loan and the amount outstanding. A municipal debt buyer must evaluate each borrower’s ability to pay based on the borrower’s total current and future obligations as reported on the most recent three years of taxes and financial reports submitted by the borrower to the municipality.
Ability to pay Example
The amount of money you earn is taxed as a percentage of your income. For Example, if you earn $40,000 a year, your income is taxed at 30 percent (that is, 30 percent of your income is taxed over your base tax rate). So If you earn $60,000, your taxes will be $6,250 (30 percent of $80,000 = $6,250).
The purpose of the ability to pay (ATP) index is to determine the ability to pay. Ability to Pay (ATP) Index is the ratio of income and payroll taxes paid plus self-employed health insurance premiums. The higher the ATP Index, the better the household is likely to be financial.
Ability to pay is the ability to meet all income obligations and make required minimum tax payments without having additional income or resources lost to tax obligations. Ability to pay can be determined by calculations of a taxpayer’s tax liability, and various calculations used to assess taxes and benefits on an annual basis.