Deadweight Loss Of Taxation

Definition

In economics, the excess burden of taxation, also known as the deadweight cost or deadweight loss of taxation, is one of the economic losses that society suffers as the result of taxes or subsidies. Economic theory posits that distortions change the amount and type of economic behavior from that which would occur in a free market without the tax. Excess burdens can be measured using the average cost of funds or the marginal cost of funds. Excess burdens were first discussed by Adam Smith.

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.

Explaining ‘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.

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.

Deadweight Loss Of Taxation

Definition