Excess burden of taxation
Encyclopedia
In economics
, the excess burden of taxation, also known as the distortionary cost or deadweight loss of taxation, is one of the economic losses that society suffers as the result of a tax. Economic theory
posits that distortions
changes 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 (MCF). Excess burdens were first discussed by Adam Smith
.
An equivalent kind of inefficiency can also be caused by subsidies (that are actually taxes with negative rates).
Economic losses due to taxes were evaluated to be as low as 2.5 cents per dollar of revenue, and as high as 30 cents per dollar of revenue (on average), and even much higher at the margins. See Martin Feldstein, Tax Avoidance and the Deadweight Loss of the Income Tax, 81(4), Review of Economics and Statistics (1999), at p. 674; Charles L. Ballard, John B. Shoven and John Whalley, The Welfare Cost of Distortions in the United States Tax System: A General Equilibrium Approach, National Bureau of Economic Research Working Paper No. 1043. For a review of literature arguing that moving to a uniform taxation of investment will lead to 0.1% to 0.3% increase in GNP, see Lawrence H. Summers, Should Tax Reform Level the Playing Field?, National Bureau of Economic Research Working Paper No. 2132, Cambridge, MA, January 1987.
The average cost of funds is the total cost of distortions divided by the total revenue collected by a government. In contrast, the marginal cost of funds (MCF) is the size of the distortion that accompanied the last unit of revenue raised (ie, the rate of change
of distortion with respect to revenue). In most cases, the MCF increases as the amount of tax collected increases.
The standard position in economics is that the costs in a cost-benefit analysis
for any tax-funded project should be increased according to the marginal cost of funds, because that is close to the deadweight loss that will be experienced if the project is added to the budget, or to the deadweight loss removed if the project is removed from the budget.
In fact almost any tax measure will distort the economy from the path or process that would have prevailed in its absence (land value tax
es are a notable exception). For example a sales tax
applied to all goods will tend to discourage consumption of all the taxed items, and an income tax
will tend to discourage people from earning money in the category of income that is taxed (unless they can manage to avoid being taxed). Some people may move out of the work force (to avoid income tax); some may move into the cash or black economies (where incomes are not revealed to the tax authorities).
For example, in Western nations the incomes of the relatively affluent are taxed partly to provide the money used to assist the relatively poor. As a result of the taxes (and associated subsidies to the poor), incentives are changed for both groups. The relatively rich are discouraged from declaring income and from earning marginal (extra) income, because they know that any additional money that they earn and declare will be taxed at their highest marginal tax rates. At the same time the poor have an incentive to conceal their own taxable income (and usually their assets) so as to increase the likelihood of their receiving state assistance. It can be argued that the distortion of incentives (the move away from a fiscally neutral stance that does not affect incentives) does more harm than good.
One of the main distortions sometimes said to have arisen in the USA and the UK
as a result of tax policy is the creation of a permanent underclass
, dependent on welfare and discouraged (by the tax system) from seeking work and betterment. In some countries the tax system can be badly designed to deal with such issues, e.g. sometimes the marginal tax rate
that applies to earned income (as someone takes work attempting to escape from unemployment and welfare) is so high that the person's take-home income (post-tax and after taking account of any benefits or welfare receipts) does not increase as a result of taking work. This is known as the welfare trap
.
There was an example of distortion of the economy by tax policy some years ago in the UK when cars supplied by employers to their employees were taxed at advantageous rates (e.g. encouraging the growth of company car fleets). Over several years the distortion grew to the point that the majority of cars used by working families were company cars and the dealership structures, and even the types of cars used, altered to adjust to the tax regime.
es create distortions that correct for externalities
and therefore have a negative MCF.
Here, the fiscal distortion is deliberate, so as to compensate for externalities. "Sin tax
es" are levied on products that incur additional costs to society, such as alcohol
, tobacco
and pollution
. Ideally, these taxes raise the price to the exact level that the market would bear if the negative externalities were included in the price. Pigovian tax
es are often preferable to outright prohibition
, since prohibition incites trafficking
, often resulting in crime
and other social costs, but no revenue.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, the excess burden of taxation, also known as the distortionary cost or deadweight loss of taxation, is one of the economic losses that society suffers as the result of a tax. Economic theory
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
posits that distortions
Distortions (economics)
A distortion is a condition that creates economic inefficiency, thus interfering with economic agents maximizing "social welfare" when they maximize their own welfare....
changes 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 (MCF). Excess burdens were first discussed by Adam Smith
Adam Smith
Adam Smith was a Scottish social philosopher and a pioneer of political economy. One of the key figures of the Scottish Enlightenment, Smith is the author of The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations...
.
An equivalent kind of inefficiency can also be caused by subsidies (that are actually taxes with negative rates).
Economic losses due to taxes were evaluated to be as low as 2.5 cents per dollar of revenue, and as high as 30 cents per dollar of revenue (on average), and even much higher at the margins. See Martin Feldstein, Tax Avoidance and the Deadweight Loss of the Income Tax, 81(4), Review of Economics and Statistics (1999), at p. 674; Charles L. Ballard, John B. Shoven and John Whalley, The Welfare Cost of Distortions in the United States Tax System: A General Equilibrium Approach, National Bureau of Economic Research Working Paper No. 1043. For a review of literature arguing that moving to a uniform taxation of investment will lead to 0.1% to 0.3% increase in GNP, see Lawrence H. Summers, Should Tax Reform Level the Playing Field?, National Bureau of Economic Research Working Paper No. 2132, Cambridge, MA, January 1987.
Measures of the excess burden
The cost of a distortion is usually measured as the amount that would have to be paid to the people affected by its supply, the greater the excess burden. The second is the tax rate: as a general rule, the excess burden of a tax increases with the square of the tax rate.The average cost of funds is the total cost of distortions divided by the total revenue collected by a government. In contrast, the marginal cost of funds (MCF) is the size of the distortion that accompanied the last unit of revenue raised (ie, the rate of change
Derivative
In calculus, a branch of mathematics, the derivative is a measure of how a function changes as its input changes. Loosely speaking, a derivative can be thought of as how much one quantity is changing in response to changes in some other quantity; for example, the derivative of the position of a...
of distortion with respect to revenue). In most cases, the MCF increases as the amount of tax collected increases.
The standard position in economics is that the costs in a cost-benefit analysis
Cost-benefit analysis
Cost–benefit analysis , sometimes called benefit–cost analysis , is a systematic process for calculating and comparing benefits and costs of a project for two purposes: to determine if it is a sound investment , to see how it compares with alternate projects...
for any tax-funded project should be increased according to the marginal cost of funds, because that is close to the deadweight loss that will be experienced if the project is added to the budget, or to the deadweight loss removed if the project is removed from the budget.
Distortion and redistribution
In the case of progressive taxes, the distortionary effects of a tax may be accompanied by other benefits: the redistribution of dollars from wealthier people to poorer people who could possibly obtain more benefit from them.In fact almost any tax measure will distort the economy from the path or process that would have prevailed in its absence (land value tax
Land value tax
A land value tax is a levy on the unimproved value of land. It is an ad valorem tax on land that disregards the value of buildings, personal property and other improvements...
es are a notable exception). For example a sales tax
Sales tax
A sales tax is a tax, usually paid by the consumer at the point of purchase, itemized separately from the base price, for certain goods and services. The tax amount is usually calculated by applying a percentage rate to the taxable price of a sale....
applied to all goods will tend to discourage consumption of all the taxed items, and an income tax
Income tax
An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
will tend to discourage people from earning money in the category of income that is taxed (unless they can manage to avoid being taxed). Some people may move out of the work force (to avoid income tax); some may move into the cash or black economies (where incomes are not revealed to the tax authorities).
For example, in Western nations the incomes of the relatively affluent are taxed partly to provide the money used to assist the relatively poor. As a result of the taxes (and associated subsidies to the poor), incentives are changed for both groups. The relatively rich are discouraged from declaring income and from earning marginal (extra) income, because they know that any additional money that they earn and declare will be taxed at their highest marginal tax rates. At the same time the poor have an incentive to conceal their own taxable income (and usually their assets) so as to increase the likelihood of their receiving state assistance. It can be argued that the distortion of incentives (the move away from a fiscally neutral stance that does not affect incentives) does more harm than good.
One of the main distortions sometimes said to have arisen in the USA and the UK
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
as a result of tax policy is the creation of a permanent underclass
Underclass
The term underclass refers to a segment of the population that occupies the lowest possible position in a class hierarchy, below the core body of the working class. The general idea that a class system includes a population under the working class has a long tradition in the social sciences...
, dependent on welfare and discouraged (by the tax system) from seeking work and betterment. In some countries the tax system can be badly designed to deal with such issues, e.g. sometimes the marginal tax rate
Marginal tax rate
In a tax system and in economics, the tax rate describes the burden ratio at which a business or person is taxed. There are several methods used to present a tax rate: statutory, average, marginal, effective, effective average, and effective marginal...
that applies to earned income (as someone takes work attempting to escape from unemployment and welfare) is so high that the person's take-home income (post-tax and after taking account of any benefits or welfare receipts) does not increase as a result of taking work. This is known as the welfare trap
Welfare trap
The welfare trap theory asserts that taxation and welfare systems can jointly contribute to keep people on social insurance because the withdrawal of means tested benefits that comes with entering low-paid work causes there to be no significant increase in total income...
.
There was an example of distortion of the economy by tax policy some years ago in the UK when cars supplied by employers to their employees were taxed at advantageous rates (e.g. encouraging the growth of company car fleets). Over several years the distortion grew to the point that the majority of cars used by working families were company cars and the dealership structures, and even the types of cars used, altered to adjust to the tax regime.
Deliberate distortion
Not all distortions are bad; Pigovian taxPigovian tax
A Pigovian tax is a tax levied on a market activity that generates negative externalities. The tax is intended to correct the market outcome. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity...
es create distortions that correct for externalities
Externality
In economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...
and therefore have a negative MCF.
Here, the fiscal distortion is deliberate, so as to compensate for externalities. "Sin tax
Sin tax
A sin tax is a kind of sumptuary tax: a tax specifically levied on certain generally socially proscribed goods and services. These goods are usually alcohol and tobacco, but also include candies, soft drinks, fat foods and coffee, while services range from prostitution to...
es" are levied on products that incur additional costs to society, such as alcohol
Alcohol
In chemistry, an alcohol is an organic compound in which the hydroxy functional group is bound to a carbon atom. In particular, this carbon center should be saturated, having single bonds to three other atoms....
, tobacco
Tobacco
Tobacco is an agricultural product processed from the leaves of plants in the genus Nicotiana. It can be consumed, used as a pesticide and, in the form of nicotine tartrate, used in some medicines...
and pollution
Pollution
Pollution is the introduction of contaminants into a natural environment that causes instability, disorder, harm or discomfort to the ecosystem i.e. physical systems or living organisms. Pollution can take the form of chemical substances or energy, such as noise, heat or light...
. Ideally, these taxes raise the price to the exact level that the market would bear if the negative externalities were included in the price. Pigovian tax
Pigovian tax
A Pigovian tax is a tax levied on a market activity that generates negative externalities. The tax is intended to correct the market outcome. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity...
es are often preferable to outright prohibition
Prohibition
Prohibition of alcohol, often referred to simply as prohibition, is the practice of prohibiting the manufacture, transportation, import, export, sale, and consumption of alcohol and alcoholic beverages. The term can also apply to the periods in the histories of the countries during which the...
, since prohibition incites trafficking
Illegal drug trade
The illegal drug trade is a global black market, dedicated to cultivation, manufacture, distribution and sale of those substances which are subject to drug prohibition laws. Most jurisdictions prohibit trade, except under license, of many types of drugs by drug prohibition laws.A UN report said the...
, often resulting in crime
Crime
Crime is the breach of rules or laws for which some governing authority can ultimately prescribe a conviction...
and other social costs, but no revenue.