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Definition: Ability to Pay
This phrase can be used in two different contexts, although both on similar lines. First, the more general one: In the theory of taxation, ability to pay is a principle which states that the amount of tax levied on an economic entity or a citizen of a nation, should be directly proportional to the wealth or income of the entity or individual. Second, a borrower’s capability to meet his or her current and/or future debt obligations.
The application of this principle is a progressive tax system, in which individuals with higher incomes are asked to pay more tax than individuals with lower incomes. The tax rate increases as a percentage along with income. In India, the taxation structure is a perfect example of ability to pay taxation principle.
Table 1 . Income tax slabs in India for male individuals below 60 years of age and HUF
Income tax slabs
Income tax rates
Total Income <=2,50,000
2,50,000 < Income <= 5,00,000
10% of the amount exceeding 2,50,000
5,00,000 < Income <= 10,00,000
20% of the amount exceeding 5,00,000
Income > 10,00,000
30% of the amount exceeding 10,00,000
Most of the countries other than India also follow a similar taxation system. Corporate income tax and property tax are also based on ability to pay principle.
Shifting the focus on the second context, when considering a loan, a banker will first and foremost consider the borrower’s ability to pay, which can be viewed as the financial capacity of the borrower to service his or her existing debts. Lenders typically use the 5 C’s of credit to analyse a borrower’s ability to pay – (i) Collateral, (ii) Capital, stable and liquid preferred, (iii) Capability to generate cash flows through employment and investments, (iv) Character of the borrower, (v) Conditions, economic or otherwise.