What is deadweight loss of taxation

Tax revenue varies with the proportion of the tax as a percentage of the product price. Usually, a moderate tax rate will yield the most tax revenue, as can be seen from the first diagram above. When the tax rate is small or high, tax revenue will be less. When the tax rate is small, the government only gets a small portion of the price paid. When the tax rate is high, then the quantity sold is much less, so even when it is multiplied by the high tax rate, it yields less revenue, which can be seen in the diagrams below.

Also illustrated is that the deadweight loss of a high tax rate is much greater than the deadweight loss of a low tax rate. A high tax rate, as a low tax rate, yields little government revenue, but the high tax rate comes at a bigger expense to the economy, since it reduces total surplus more: fewer people will be able to enjoy the goods and services subject to the high tax rate.

Of course, this is desirable for excise taxes on goods or services that are detrimental to people or society, such as tobacco and alcohol consumption. In this case, a high tax rate not only earns some revenue for the government, but also promotes more desirable goals. As can be seen in this schematic graph, as taxes are increased, the deadweight loss of the tax also increases, gradually at first, then steeply as the size of the tax approaches the market price of the product without the tax.

Likewise, tax revenue increases at first, but then starts to decline as a decrease in quantity more than offsets the increase in the tax rate. The economic effects of taxation are often applied to labor, especially since the effective tax rate on labor is extremely high.

Although there is no question that there is a deadweight loss from taxes on labor, economists differ as to the size of the deadweight loss, since it depends on the demand and supply elasticity of labor. In the s, Arthur Laffer argued that tax revenue can be increased by reducing the tax rate. He argued that tax revenue generated from labor increases at first, but then, at a certain point, it starts to decline until it reaches zero.

In the s, the Republicans presented this argument as a way to increase tax revenue by actually lowering tax rates. Of course, this argument only makes sense if anyone knew that the economy was actually past the point of maximum tax revenue. He argued that if taxes were lower, then people would work harder, yielding more tax revenue. This came to be known as supply-side economics , because lower taxes increases the supply of everything, but especially labor. While the above argument somewhat makes sense, the supply of labor is relatively inelastic, since most everyone except the wealthy must work to survive.

Hence, the tax burden on labor falls on labor, best evidenced by the fact that when Bill Clinton increased the tax rate, particularly on the wealthy, tax revenue increased proportionately. Deadweight loss effects demonstrate why policymakers should pursue a more efficient tax code to achieve distributional objectives, rather than pursuing high tax rates that create disproportionately high economic costs.

Policies such as broadening the base, lowering rates, and limiting deductions and exclusions, rather than policies to raise income tax rates to higher levels, would result in less loss of economic efficiency. If policymakers conclude that new revenue is needed, they should consider the deadweight loss of different tax policy options. The Tax Foundation works hard to provide insightful tax policy analysis.

Our work depends on support from members of the public like you. Would you consider contributing to our work? We work hard to make our analysis as useful as possible. Would you consider telling us more about how we can do better? Your Money. Personal Finance. Your Practice. Popular Courses. Taxes Income Tax. Key Takeaways Deadweight loss of taxation measures the overall economic loss caused by a new tax on a product or service. It analyses the decrease in production and the decline in demand caused by the imposition of a tax.

It is a lost opportunity cost. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Terms Welfare Loss Of Taxation Definition Welfare loss of taxation refers to the decreased economic well-being caused by the imposition of a tax.

Deadweight Loss A deadweight loss is a cost to society created by market inefficiency, which occurs when supply and demand are out of equilibrium.

What Is a Price Ceiling? A price ceiling is a maximum amount, mandated by law, that a seller can charge for a product or service. It's generally applied to consumer staples. The loss of welfare attributed to the shift from earlier to this less efficient market mechanism is called the deadweight loss of taxation. This leads to wastage or underutilization of resources due to inefficient market outcomes. Service tax is a tax levied by the government on service providers on certain service transactions, but is actually borne by the customers.

It is categorized under Indirect Tax and came into existence under the Finance Act, Description: In this case, the service provider pays the tax and recovers it from the customer. Service Tax was earlier levied on a specified list of services, but in th. A nation is a sovereign entity.

Any risk arising on chances of a government failing to make debt repayments or not honouring a loan agreement is a sovereign risk.

Description: Such practices can be resorted to by a government in times of economic or political uncertainty or even to portray an assertive stance misusing its independence. A government can resort to such practices by easily altering. A recession is a situation of declining economic activity. Declining economic activity is characterized by falling output and employment levels.

Generally, when an economy continues to suffer recession for two or more quarters, it is called depression. Description: The level of productivity in an economy falls significantly during a d.

It is always measured in percentage terms.