Deadweight Loss Of Taxation

What is 'Deadweight Loss Of Taxation'

The deadweight loss of taxation refers to the harm caused to economic efficiency and production by a tax. In other words, the deadweight loss of taxation is a measurement of how far taxes reduce the standard of living among the taxed population. English economist Alfred Marshall (1842-1924) is widely credited with first developing deadweight loss analysis.

BREAKING DOWN 'Deadweight Loss Of Taxation'

The deadweight loss of taxation is normally represented graphically. After a tax is imposed, it forces the supply curve of some good or service (or in aggregate cases consumer spending) left along the demand curve. The vertical change between the two levels of output, measuring additional net receipts to the government, is smaller than the loss in productive output except in cases where the supply curve is perfectly vertical. The difference between the new taxes and the total reduction in output is the deadweight loss.

Hypothetical Example

Imagine the U.S. federal government imposes a 40% income tax on all citizens. Through this exercise, the government collects an additional $1.2 trillion in taxes. However, those funds are no longer available to be spent in private markets. Suppose consumer spending and investments decline at least $1.2 trillion, and total output declines $2 trillion. In this case, the deadweight loss is $800 billion.

Causes of Deadweight Loss

Not everyone agrees deadweight loss can be accurately measured, but virtually all economists acknowledge that taxation is inefficient and distorts free markets.

Taxes result in a higher cost of production or higher purchase price in the market. This, in turn, creates a smaller production volume than would otherwise exist. The gap between the taxed and tax-free production volumes is the deadweight loss. Neoclassical analysis says the amount of loss depends on the shapes and elasticities of the supply and demand curves.

Taxation reduces the returns from investments, wages, rents, entrepreneurship and inheritance. This reduces the incentive to invest, work, deploy property, take risks and save. It also encourages taxpayers to spend time and money trying to avoid their tax burden, further diverting valuable resources from other productive uses.

Most governments levy taxes disproportionately on different people, goods, services and activities. This distorts the natural market distribution of resources from there otherwise optimal construct, away from heavily taxed activities and into lightly taxed activities.

Deadweight Loss of Government Deficit Spending and Inflation

The economics of taxation also apply to other forms of government financing. If the government finances activities through government bonds instead of immediate taxation, deadweight loss is only delayed until higher future taxes must be levied to pay off the debt. Deficit spending also crowds out present private investment and diverts present production — otherwise determined by subjective consumer valuations — from its most efficient areas.

The deadweight loss of inflation is nuanced. Inflation reduces the economy’s production volume in three ways: individuals divert resources towards counter-inflationary activity; governments engage in more spending and deficit financing, the so-called “hidden tax;” and expectations of future inflation reduce present private expenditures.