Excess burden of taxation
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In economics, the excess burden of taxation, also known as the distortionary cost or deadweight loss of taxation, is the economic loss society suffers as the result of a tax, over and above the revenue it collects. Distortions occur because people or firms change their behaviour in order to reduce the amount of tax they must pay. Excess burdens can be measured using the average cost of funds or the marginal cost of funds (MCF).
An equivalent kind of inefficiency can also be caused by subsidies that change the relative prices of different goods.
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[edit] Examples
An extreme example of a distortionary cost is a welfare trap. Suppose that an unemployed person named Jane is subsisting on a minimal welfare payment. Jane considers taking a job that would require her to work for tens of hours per week, but remunerate her with tens of thousands of dollars a year. She finds the hourly wage persuasive. But in some real-world cases, people like Jane move from the welfare system to the tax system if they take the job, effectively being taxed 70% or 80% of the dollars they earn. Jane may rationally decide that it would be better to stay on welfare and have a great deal more free time.
Society is losing out, however. If everyone agreed in this one case to let Jane pay no tax on her new job, but cut her welfare payments in half, then everyone would be better off. Jane would likely be better off because she now has a much higher income (it is usually assumed that she wouldn't take the job if she wasn't going to be better off). The government (and therefore other taxpayers) are definitely better off, because Jane's cost to the welfare system has been sliced in half. It is this possibility for a Pareto improvement that leads to the burden being called a "deadweight loss".
Although it is less obvious, a similar deadweight loss will occur if the government taxes apples but not oranges, thereby encouraging Jane to eat more oranges.
[edit] 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 it, in order to make them indifferent to its presence.
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.
[edit] 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 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 taxes 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 (if 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 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.
[edit] Deliberate distortion
- For more details on this topic, see Pigovian tax.
Not all distortions are bad: Pigovian taxes 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 taxes" on alcohol, tobacco, pornography... may be levied so as to discourage excessive consumption. Such an approach is often preferable to outright prohibition, since prohibition incites trafficking, often resulting in crime. Similarly, taxes, such as a carbon tax, may be levied on the issuing of pollutants, in order to incite corporations to adopt cleaner methods of production.
[edit] Other notes
Excess burdens were first discussed by Adam Smith.
Georgism is a political philosophy that advocates land value taxation because (amongst other reasons) it is non-distortionary.
