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.

The difference between the imposition of new taxes and the total reduction in output due to these new taxes is the deadweight loss. After a tax is imposed, it forces the supply curve of some good, service, or consumer spending left along the demand curve. A deadweight loss of taxation is customarily represented graphically. 

In other words, the change between the two levels of output, when measuring additional net receipts to the government, is smaller than the loss in productive output except in cases where the supply curve is perfectly flat or vertical. 

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

Not everyone agrees deadweight loss can be accurately measured. However, virtually all economists acknowledge that taxation is inefficient and distorts the free market.

Taxes result in a higher cost of production or higher purchase price in the market. This, in turn, creates a smaller production volume 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.

Taxation reduces the returns from investments, wages, rents, entrepreneurship, and inheritance. This, in turn, reduces the incentive to invest, work, deploy property, take risks, and to save. It also encourages taxpayers to spend time and money trying to avoid their tax burden, further 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 the heavily taxed activities and into lightly taxed activities, which may not be as advantageous.

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 redirects present production, which is determined by subjective consumer valuations, away from its most efficient areas.

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

1. Individuals divert resources towards counter-inflationary activity
2. Governments engage in more spending and deficit financing also called “hidden tax”
3. Expectations of future inflation reduce present private expenditures.