Discuss the approaches to tax equity with special reference to ‘ability to pay principle.

Discuss the approaches to tax equity with special reference to ‘ability to pay principle.’

User pays, or beneficiary pays, is a pricing approach based on the idea that the most efficient allocation of resources occurs when consumers pay the full cost of the goods that they consume. In public finance it stands with another principle of "ability to pay," which states that those who have the means should share more of the burden of public services. The ability to pay principle is one the reasons for the general acceptance of the progressive income tax system.

The principle of user pay supports the idea of horizontal equity, which states that those in similar wealth and income positions should be treated equally by the tax system. The basic idea is that those who do not use a service should not be obligated to pay for it. As long as the beneficiary aligns exactly with the user, the user pay principle works. Those who do not go to a movie are not obligated to pay for someone else to attend.

In public goods, beneficiaries and users often do not align. The divergence of user and beneficiary occurs when production and consumption have external effects. The driver, who purchases gasoline, may believe he or she is paying for the full cost (user pay) of using gasoline, except that greenhouse gases are produced. These impose costs on the environment and are believed to contribute to climate change. The "beneficiaries" must bear costs not paid in the purchase of gasoline. In this case the user pay principle results in the driver not paying the full or social cost of using fossil fuels, which creates a strong argument for regulation and other forms of public intervention. Increasing taxes on gasoline is one possible response that preserves the user pay principle by increasing the costs to user.