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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.

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.


Further Reading


Tax avoidance and the deadweight loss of the income tax
www.mitpressjournals.org [PDF]
… expenses in a model of labor supply but does not analyze the welfare implications or note … Measuring the change in the dead- weight loss that would result from a change in the income tax … Similarly, there is no attempt to deal with the deadweight losses that arise from the rules …

Compensating and equivalent variations, and the deadweight loss of taxationCompensating and equivalent variations, and the deadweight loss of taxation
www.jstor.org [PDF]
… expenses in a model of labor supply but does not analyze the welfare implications or note … Measuring the change in the dead- weight loss that would result from a change in the income tax … Similarly, there is no attempt to deal with the deadweight losses that arise from the rules …

Correct and incorrect measures of the deadweight loss of taxationCorrect and incorrect measures of the deadweight loss of taxation
ideas.repec.org [PDF]
… expenses in a model of labor supply but does not analyze the welfare implications or note … Measuring the change in the dead- weight loss that would result from a change in the income tax … Similarly, there is no attempt to deal with the deadweight losses that arise from the rules …

Taxation and deadweight loss in a system of intergovernmental transfersTaxation and deadweight loss in a system of intergovernmental transfers
www.jstor.org [PDF]
… expenses in a model of labor supply but does not analyze the welfare implications or note … Measuring the change in the dead- weight loss that would result from a change in the income tax … Similarly, there is no attempt to deal with the deadweight losses that arise from the rules …

Taxes, organizational form, and the deadweight loss of the corporate income taxTaxes, organizational form, and the deadweight loss of the corporate income tax
www.sciencedirect.com [PDF]
… expenses in a model of labor supply but does not analyze the welfare implications or note … Measuring the change in the dead- weight loss that would result from a change in the income tax … Similarly, there is no attempt to deal with the deadweight losses that arise from the rules …

Exact consumer's surplus and deadweight lossExact consumer's surplus and deadweight loss
www.jstor.org [PDF]
… expenses in a model of labor supply but does not analyze the welfare implications or note … Measuring the change in the dead- weight loss that would result from a change in the income tax … Similarly, there is no attempt to deal with the deadweight losses that arise from the rules …

Deadweight loss and taxation of earned income: evidence from tax records of the UK self-employedDeadweight loss and taxation of earned income: evidence from tax records of the UK self-employed
www.econstor.eu [PDF]
… expenses in a model of labor supply but does not analyze the welfare implications or note … Measuring the change in the dead- weight loss that would result from a change in the income tax … Similarly, there is no attempt to deal with the deadweight losses that arise from the rules …

Nonparametric estimation of exact consumers surplus and deadweight lossNonparametric estimation of exact consumers surplus and deadweight loss
www.jstor.org [PDF]
… expenses in a model of labor supply but does not analyze the welfare implications or note … Measuring the change in the dead- weight loss that would result from a change in the income tax … Similarly, there is no attempt to deal with the deadweight losses that arise from the rules …

The economic cost of inadequate sleepThe economic cost of inadequate sleep
academic.oup.com [PDF]
… expenses in a model of labor supply but does not analyze the welfare implications or note … Measuring the change in the dead- weight loss that would result from a change in the income tax … Similarly, there is no attempt to deal with the deadweight losses that arise from the rules …

Measuring the deadweight loss from taxation in a small open economy: A general method with an application to SwedenMeasuring the deadweight loss from taxation in a small open economy: A general method with an application to Sweden
www.sciencedirect.com [PDF]
… expenses in a model of labor supply but does not analyze the welfare implications or note … Measuring the change in the dead- weight loss that would result from a change in the income tax … Similarly, there is no attempt to deal with the deadweight losses that arise from the rules …



Q&A About Deadweight Loss Of Taxation


Do you agree that taxing can be inefficient and distort free markets?

Yes, I agree that taxing can distort free markets because it takes away resources

Are there different types of taxes with different kinds of effects on society?

Yes, there are different types. Some have more harmful effects than others.

What happens when consumer spending and investments decline as a result of higher taxes imposed on them?

Total output declines as well.

What happens when government imposes a tax on its citizens?

The government collects an additional amount in taxes, but those funds are no longer available to be spent in private markets.

Who first developed deadweight loss analysis?

Alfred Marshall (1842-1924).

How do economists measure deadweight losses from taxation?

They measure it by how much consumer spending and investment decline due to higher taxes imposed on them.

How is deadweight loss measured?

It is measured by how far taxes reduce the standard of living among the taxed population.

Why are some people skeptical about measuring deadweight losses from taxation accurately?

Some people believe that it is difficult to accurately measure because there are many factors involved with calculating these losses, such as the elasticity of demand for goods or services, and whether or not consumers will substitute other goods for ones they would have purchased if they did not have to pay more for them due to taxation. Another reason why some people may be skeptical about measuring this type of loss is because there may be other reasons why consumers spend less money than before; such as their income has decreased or they are saving money for something else instead of spending it all now.

What is the excess burden of taxation?

The excess burden of taxation is one of the economic losses that society suffers as a result of taxes or subsidies.

What does economics say about distortions caused by taxes?

Economics says that distortions change the amount and type of economic behavior from what would occur in a free market without the tax.

What does deadweight loss of taxation refer to?

Deadweight loss of taxation refers to the harm caused to economic efficiency and production by a tax.