Deadweight Loss Of Taxation: Definition, How It Works and Example

What Is a Deadweight Loss Of Taxation?

The term deadweight loss of taxation refers to the measurement of loss caused by the imposition of a new tax. This results from a new tax that is more than what is normally paid to the government's taxing authority. This theory suggests that imposing a new tax or raising an old one can backfire, resulting in insufficient or no gains in government revenues due to the decline in demand for the goods or services being taxed. A deadweight loss, therefore, disrupts the balance between supply and demand. English economist Alfred Marshall is widely credited as the originator of deadweight loss analysis.

Understanding Deadweight Loss of Taxation

Governments impose taxes to collect revenues. These funds are used to support public programs and projects, such as infrastructure, economic aid, and social services. Federal, state, and local governments frequently decide to raise taxes in order to raise revenues to cover shortfalls. Although this action may seem like a good idea, it often has the opposite effect. This is called a deadweight loss of taxation or, simply, a deadweight loss.

Here's how it works. When the government raises taxes on certain goods and services, it collects that tax as additional revenue. Taxes, though, result in a higher cost of production and a higher purchase price for the consumer. This, in turn, causes production volumes (and, therefore, supply) to drop, leading to a drop in demand for these goods and services. This gap between the taxed and tax-free production volumes is the deadweight loss. 

This theory was developed by Alfred Marshall, an economist who specialized in microeconomics. According to Marshall, supply and demand are directly related to production and cost. These points intersect in the middle. So, when one changes, it throws off the balance.

Although there isn't a consensus among experts about whether deadweight loss can be accurately measured, many economists agree that taxation can often be counter-productive. This makes a deadweight loss of taxation a lost opportunity cost.

Special Considerations

Taxation reduces the returns from investments, wages, rents, and entrepreneurship. This, in turn, reduces the incentive to invest, work, deploy property, and take risks. But it also encourages taxpayers to spend time and money trying to avoid their tax burden, 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. The limited resources will move from their otherwise optimal use, away from heavily taxed activities and into lightly taxed activities, which may not be advantageous to all.

Deadweight Loss of Deficit Spending and Inflation

The economics of taxation also apply to other forms of government financing. If a government finances activities through bonds rather than taxation, deadweight loss is only delayed. Higher future taxes must be levied to pay off the bond debt.

The deadweight loss of inflation is nuanced. Inflation reduces the economy’s production volume in three ways:

• Individuals divert resources towards counter-inflationary activities.
• Governments engage in more spending and deficit financing becomes a hidden tax.
• Expectations of future inflation reduce present private expenditures.

Example of Deadweight Loss of Taxation

Here's a hypothetical example to show how the deadweight loss of taxation works. Let's say the mythical city-state of Braavos imposes a flat 40% income tax on all of its citizens. The government stands to collect an additional $1.2 trillion a year through this new tax.

That big chunk of money, which is now going to the government of Braavos, is no longer available for spending on consumer goods and services, or for consumer savings and investment.

Suppose consumer spending and investments decline at least $1.2 trillion, and total economic output declines by $2 trillion. In this case, the deadweight loss is $800 billion—the $2 trillion total output less $1.2 trillion consumer spending or investing equals a deadweight loss of $800 billion.