What is the Ability to Pay?

Osmand Vitez

The ability to pay is a finance term that relates to an individual’s cash flow for repaying loans. Another commonly associated definition is the ability for individuals with high incomes to pay more taxes. Both concepts relate to cash flow situations for both individuals and businesses. In the first scenario, banks and lenders assess how well a borrower will be able to pay back the principle and interest relating to a loan. This assessment and decision comes from the loan application process where banks and lenders look at credit history and cash flow. The latter focuses on income redistribution through government taxation.

Those with a limited cash flow may have a hard ability to pay.
Those with a limited cash flow may have a hard ability to pay.

Borrowing money gives individuals and businesses the opportunity to purchase large or high-value dollar items when they do not have adequate cash flow. Individuals are constrained by personal income, while companies have constraints that relate to sales revenue and profit after business expenses. The ability to pay is important when borrowing money as banks and lenders increase their risk when lending money. If borrowers cannot repay the balance, the financial institution will likely lose the loan to default and have to repossess the property rather than earning the interest income from the loan.

Credit history is one indicator that determines a person's ability to pay.
Credit history is one indicator that determines a person's ability to pay.

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In relation to taxation, the ability to pay is a redistributive concept where poorer or low-income individuals and families are spared heavy tax burdens. This ultimately results in high-income earners bearing more tax burden. In theory, this redistributes wealth since well-to-do individuals and families will have to separate themselves from their money by paying it to the government. Poor and low-income taxpayers will be able to retain their money, completing the cycle of redistribution. These taxpayers may also receive credits, tax refunds, subsidies or other government-funded benefits through the ability to pay concepts.

Redistribution of wealth through taxation is typically found in nations or economies that favor socialism, although communist economies will also have these features. Socialist economies attempt to deliver a sense of lifestyle equality among citizens. Rather than having a small group of high-earning individuals or families in the economy control the economy, socialism tends to bring up poorer taxpayers through government programs.

The ability to pay does have initial short-term benefits as it allows low-income taxpayers to keep more money. This will increase consumption from this demographic and spur the production process of goods and service in the local economy. However, drawbacks also exist to this concept. For example, taking money away from high-income taxpayers — who tend to be business owners and job producers — will be unable to support the economy from their collective business actions.

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