Taxable Capacity: Concept and Factors influencing Taxable Capacity

What is Taxable Capacity?

Taxable Capacity is the maximum capacity of the people of a country to bear the taxation burden without many problems. Simply put, it is the maximum limit to which the government of a country can tax its people. Therefore, if the government of a country exceeds its taxation limit, it will lead to over-taxation harming the long-term interests of the community. Besides, it may also pose a serious threat to the political stability of the country.

The term taxable capacity holds an important place in public finance. Also, it has great practical importance for every country’s Finance Minister. It is because, the Finance Minister of a country while imposing new taxes or increasing the existing tax rates, keeps taxable capacity in mind. If the Finance Minister of a country levies taxes above the taxable capacity, then it will produce discontent among people on a large scale and those people will start to oppose it. Similarly, if the tax levied is way below the taxable capacity, then it would mean that the Finance Minister is unnecessarily denying the share of revenue out of the taxes to the government. Therefore, it is the duty of the Finance Minister to levy taxes based on the taxable capacity of the country.

Taxable Capacity is an important concept, both during peacetime and during wartime. During peacetime, the concept of taxable capacity proves to be indispensable in terms of mobilisation of maximum financial resources for the planned development of the economy. However, during wartime, the concept of taxable capacity lays down the maximum limit to which the government can tax people. It is done to ensure adequate resources for war prosecution. Thus, the concept of taxable capacity can be interpreted in two senses:

• Absolute Capacity of one single community
• Relative Capacity of two or more communities

1. Absolute Taxable Capacity

It is the absolute limit up to which the government can tax a community. Simply put, absolute taxable capacity represents the maximum tax that the government can collect from the citizens of a specific country. Different economists have interpreted the meaning of absolute taxable capacity in different ways. For instance, according to Sir Josiah Stamp, absolute taxable capacity is total production minus the amount required to maintain the population at the subsistence level. However, his definition has two drawbacks; i) measuring the subsistence level of a community is not possible. While concretizing the subsistence level of a community the chances of facing differences are high. ii) If the total amount calculated after subtracting the subsistence level from total production is taken away from the citizens of a country in the form of taxes, then their living standards will be affected, resulting in a decline in their efficiency. This will also reduce the production of goods and services, further causing a fall in the future productive capacity of the community.

After realising these issues with his definition, Sir Josiah Stamp presented an alternative definition of absolute taxable capacity. The new definition states that the absolute taxable capacity of a country is represented by the difference between total production and total consumption. He also states two limits to a country’s taxable capacity. i) check to the total production. ii) check to total revenue yield because of the higher tax rates. 

If an increase in the tax rates leads to lower production of goods and services in a country and does not bring any additional revenue to the government, then it should be presumed that the country has reached its taxable capacity.

2. Relative Taxable Capacity

As compared to absolute taxable capacity, the term relative taxable capacity is more concrete, definite, and intelligible. It refers to the proportionate contribution that two or more than two communities can make in the form of taxes with the motive of meeting some common expenditures. Simply put, it is a community’s capacity to make a contribution to some common expenditures in relation to other communities’ capacities. The possibility of laying down the proportion in which two or more communities should provide a contribution to meet some common expenditure according to their respective ability to pay in advance is high. Besides, it is only viable that the richer community should be called upon to bear the larger share of these common expenditures. Also, if the common expenditure rises, the contribution of the richer community shall increase at a higher rate than the increasing rate of the poorer community. 

For instance, the total expenditure of the United Nations organisation is distributed among different member nations according to their relative taxable capacity. The richer nations are asked to contribute a larger proportion of the expenditure. Therefore, the relative taxable capacity should be expressed as the ratio of the taxable capacity of one unit or section of the community to that of the other unit or section of the community.

However, Professor Musgrave relates taxable capacity’s notion with the concept of income per capita income. Simply put, he states that if the per capita income is higher, then the relative taxable capacity will also be higher.

There does not exist any relationship between the relative taxable capacity and the absolute taxable capacity. It means that there might be a possibility that a country is contributing towards its common expenditures more than its relative taxable capacity. But, it does not mean that the absolute taxable capacity of the country has been reached. 

Similarly, it might be possible that a country has been taxed above its absolute taxable capacity. However, it does not mean that the relative capacity of the country has been exceeded in its contribution towards a common expenditure.

Factors Influencing Taxable Capacity

The variables affecting taxable capacity may be divided into several categories. The following are some important elements that affect the taxable capacity of a country:

1. Taxpayer Psychology: The way people feel and think about taxes can have a big impact on whether they follow the rules and pay their taxes willingly. Several factors can affect a person’s ability to pay taxes, including how much they believe in the importance of paying taxes, how much they trust the government, and whether they think the tax system is fair. For example, during wartime people are prepared to make greater sacrifices for the country and pay more tax.

2. Nature of the Government: A democratically elected government can raise more revenues from the public by winning public cooperation and sympathy. Therefore, in a democratic country, the taxable capacity of the people is higher as compared to a country that is ruled by a dictatorial type of government.

3. Administrative Setup of the Country: The administrative setup of a country also has an impact on its taxable capacity. For instance, a slave country generally has a low taxable capacity. It is because the people living in a slave country do not trust the foreign government and thus are not prepared to pay more taxes to it. During British rule, the taxable capacity of people living in India had a pretty low taxable capacity. Also, in a democratic country, the taxable capacity of the people is higher as compared to a country that is ruled by a dictatorial type of government. It is because the government in a country with a democratic setup can easily win the sympathy and goodwill of the people as compared to the government with a dictatorial setup.

4. State of Economic Development: The stage of the economic development of a country also acts as a factor in determining its taxable capacity. In general, a country with industrial advancement has high taxable capacity as compared to an underdeveloped or backward country.

5. Nature of the Taxation System of the Country: A country with a taxation system devised on a scientific basis will have high taxable capacity. Besides, if the government levies taxes under a scientific system, it will satisfy the canons of simplicity, certainty, and convenience, making the taxable capacity high. However, it should be kept in mind that if the taxation system of a country produces adverse effects on people’s productive capacity, then its taxable capacity will inevitably reduce.

6. Nature of Government Expenditure: If the government of a country incurs a major part of its expenditure to encourage production and to increase the efficiency level of workers, it will raise its taxable capacity. When the government spends a major part of its revenue on the industrial, agricultural, and transport development of the country, it will increase the taxable capacity during a time period. However, when the government spends a major part of its revenue on arms and ammunition, or to prepare for war, then the taxable capacity will be lower. 

7. Size of Income and Wealth: A country with greater income and wealth will have greater taxable capacity. 

8. Wealth Distribution in the Country: If the wealth of a country is unequally distributed, then its taxable capacity will be higher. It is because, under such circumstances, the government can secure adequate income by levying taxes on the richer section of the community. However, if the wealth is equally distributed, then the taxable capacity will be lower. It is because if the wealth is equally distributed, the overwhelming proportion of poor people will then spend their income to satisfy their basic life necessities, declining the taxable capacity of the country.

9. Increase in Production: In general, the taxable capacity of a country depends upon the population size. While keeping other things constant, if the population size increases, the taxable capacity of the country will decline. It is because that expenditure on consumption will increase with an increase in population. However, if the increase in the productive capacity of the country and the increase in its population are the same, then the taxable capacity of the country will remain unaffected.

10. Standard of Living of the People: The living standard of the citizens of a country also helps in determining its taxable capacity. If the standard of living of the people is high then their productive power will also be high. It means that the income level of these people will be high, increasing their capacity to pay taxes in the same proportion.

11. Income Stability: The taxable capacity of a country is also influenced by the stability of national income. Generally, the national income of developed countries like the USA is stable in such a way that there are no violent fluctuations in their national income. However, a country like India lacks stability in the national income. Therefore, the overwhelming majority of the people fulfil their livelihood from agriculture. But, as we know that agriculture is dependent totally on the monsoons, and if it fails; i.e., if the country faces drought, then the national income of the country will have a huge fall. Therefore, devising the taxation system on a scientific basis on account of unstable national income becomes quite difficult. Thus, the taxable capacity of such countries is usually low.

12. Inflation: While studying the taxable capacity of a country, one cannot ignore the inflationary spiral existing in the country. It happens because, due to inflation, deep repercussions arise on the taxable capacity of the country. Also, due to inflationary factors, the prices of goods and services increase; however, the purchasing power remains unchanged. Thus the real income of the country is reduced and the taxable capacity also reduces in that proportion.