What is a Deadweight Loss Of Taxation

The deadweight loss of taxation is a measurement of the economic loss that is caused by the imposition of a new tax. English economist Alfred Marshall (1842-1924) is widely credited as the originator of deadweight loss analysis.

Key Takeaways

  • Deadweight loss of taxation measures the overall economic loss caused by a new tax on a product or service.
  • It analyses the decrease in production and the decline in demand caused by the imposition of a tax.
  • It is a lost opportunity cost.

The theory posits 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. The equilibrium between supply and demand has been disrupted.

Understanding Deadweight Loss of Taxation

Deadweight loss of taxation may be viewed as the overall reduction in demand and the subsequent decline in production levels that follow the imposition of a tax. This is usually represented graphically.

The graph illustrates the supply curve for the product or service that is being taxed alongside the demand curve for it. The difference represents the deadweight loss of taxation.

Example of Deadweight Loss of Taxation

Imagine the mythical city-state of Braavos imposed a flat 40% income tax on all of its citizens. Through this tax, the government will collect an additional $1.2 trillion a year in taxes.

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. ($2 trillion total output less $1.2 trillion consumer spending or investing equals $800 billion deadweight loss).

Effects of Deadweight Loss

Not everyone agrees that deadweight loss can be accurately measured. However, many economists agree that taxation can be counter-productive.

Deficit spending means borrowing, which only delays deadweight loss of taxation to some future date when the debt must be repaid.

Taxes result in a higher cost of production or a higher purchase price for the consumer. This, in turn, causes a lower production volume and product demand 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.

Arguments Against Taxation

Taxation reduces the returns from investments, wages, rents, and entrepreneurship. This, in turn, reduces the incentive to invest, work, deploy property, and take risks.

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.