DEFINITION of Welfare Loss Of Taxation

Welfare loss of taxation refers to the decreased economic well-being caused by the imposition of a tax. It measures the effect of deadweight loss caused by a change in taxes or the tax system.

Welfare loss of taxation is also called the excess burden of taxation or deadweight loss of taxation.

BREAKING DOWN Welfare Loss Of Taxation

Taxes directly affect the prices of goods, which affect quantities demanded due to behavioral responses, which, in turn, indirectly affect the price of other goods. Imposing taxes on any product or activity makes it less attractive and gives people less incentive to purchase or participate in it. Taxpayers not only suffer from having less money because of the tax, they also suffer because the tax may change their behavior. Taxation results in deadweight loss which results in the economy functioning below optimal levels. This loss is referred to as the welfare loss of taxation.

The welfare loss occurs because in addition to the tax taking money from taxpayers (that is, the burden of the tax) it also alters their behavior because taxpayers have an incentive to act to avoid the tax (that is, the excess burden). Taxes encourage taxpayers to spend time and money trying to avoid their tax burden, further diverting valuable resources from other productive uses. A tax may also cause individuals to buy less than they would prefer or to buy a different product or service than they really wanted. Furthermore, taxation can lead workers to take additional leisure time rather than incentivizing them to work more when they know they will lose 35% of any additional dollar they earn to taxes. In effect, working more means increasing productivity which will result in more taxation. The higher the tax, the greater the welfare loss of taxation.

Actions undertaken only to avoid paying taxes creates a market inefficiency. The welfare loss of taxation is measured as change in consumer and producer surplus minus tax collected. The inefficiency of any tax is determined by the extent to which consumers and producers change their behavior to avoid the tax; deadweight welfare loss is caused by individuals and businesses making inefficient consumption and production choices in order to avoid taxation.

Imagine the U.S. federal government imposes a 40% income tax on all citizens. Through this tax, the government will collect an additional $1.2 trillion in taxes. However, those funds, which are now going to the government, are no longer available for spending 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.

Although it is argued that welfare loss of taxation cannot be measured accurately, all economists acknowledge that taxation is inefficient and distorts the free market. Since taxes in general are levied on consumption, income, and income-producing activities, higher tax burdens result in lower income and growth.