Another important set of principles deals with the proportionality of taxes with respect to income, that is, what proportion of income is paid in taxes at different incomes levels. The three alternatives are proportional (equal proportion at every income level), progressive (a higher proportion of income at higher incomes), and regressive (a higher proportion of income at lower incomes).

Public finance is further concerned with the equity and "fairness" of who pays taxes and who should pay taxes. This leads to two noted principles -- the benefit principle (those who benefit from a good pay the taxes) and the ability-to-pay principle (those who have the income pay the taxes). When applying the ability-to-pay principle to types of equity warrant further concern -- horizontal equity (equal incomes pay equal taxes) and vertical (higher incomes pay higher taxes).

Tax Effects

• Revenue Effect: The primary reason governments impose taxes is to generate the revenue used to finance the operation of government, most notably the provision of public goods. Governments need access to resources to build highways, defend the nation, educate the population, and maintain the legal system. They purchase these resources with tax revenue.


• Allocation Effect: A second reason governments impose taxes is to change the allocation of resources. Because people would rather not pay taxes, taxes create disincentives to produce, consume, and exchange. If society deems that less of a particular good, such as alcohol, pollution, or cigarettes are "bad," then a tax can reduce its production and consumption, and thus change the allocation of resources.

Tax Proportionality

• Proportional: A proportional tax is one in which the proportion of income paid in taxes is the same for all income levels. A proportional income tax exists, for example, if ever taxpayer pays exactly 20% of their income in taxes, that is, the same tax rate.


• Progressive: A progressive tax is one in which the proportion of income paid in taxes is greater for higher income levels. A progressive income tax exists, for example, if taxpayers with more income pay a 25% of their income in taxes, while those with less income pay 20%.


• Regressive: A regressive tax is one in which the proportion of income paid in taxes is smaller for higher income levels. A regressive income tax exists, for example, if taxpayers with more income pay a 15% of their income in taxes, while those with less income pay 20%.

Tax Equity

• Benefit Principle: The benefit principle states that taxes should be based on the benefits received, that is, those who receive the greatest benefits should pay the most taxes. On the surface, this principle is quite logical and easily justified. The people who benefit from public goods are logically the ones who should pay for their provision. Drivers should pay for highways, library patrons should pay for libraries, students should pay tuition, camping enthusiasts should pay for national parks, and the list goes on.
  
  However, the benefit principle does not work well for the efficient provision of public (and near-public) goods. Due to nonrival consumption, such goods are efficiently allocated with a zero price. If those who benefit directly from a public or near-public good pay a price equal to the value derived, as would be the case for private goods, then the "quantity demanded" declines and so too does the overall level of benefit generated. This is not efficient.


• Ability-to-Pay Principle: An alternative criterion is the ability-to-pay principle, which states that taxes should be based on the ability to pay taxes, that is, those who have more income should pay more taxes. This principle also makes a great deal of sense, especially for the provision of public goods that are consumed by all. If everyone benefits from public goods, without exclusion, then everyone should pay. However, not everyone CAN pay, so those who CAN afford to pay, need to bear the burden.
  
  Because taxes are a means of transferring the purchasing power of income to governments, the ability to pay is based on income. Those who have more income can afford to pay more taxes, that is, they have a greater ability to pay.

• Horizontal Equity: This tax equity principle states that people with the same ability to pay taxes should pay the same amount of taxes. If two people each earn $50,000 of income, and one pays $5,000 income taxes, a rate of 10%, then horizontal equity means the other should pay the same $5,000 and 10%.


• Vertical Equity: This tax equity principle states that people with a different ability to pay taxes should pay a different amount of taxes. If one person earns $50,000 of income and pays $5,000 income taxes, a rate of 10%, then vertical equity means another person who earns less, say $5,000 of income, should pay fewer taxes, say $500.