Deadweight Loss of Taxation

The largest amount of revenue raised by governments comes from taxation of market transactions, especially the taxation of labor. Taxes obviously lower the value of transactions to both buyers and sellers, in that, to some extent, the buyer pays more for the product and the supplier receives less. Some of that loss of value goes to the government, which, of course, is why it collects taxes. However, it has long been recognized that the loss of value to the market participants is greater than the gain to the government. Therefore, the economy as a whole loses some value from taxation, and this complete loss is referred to as the deadweight loss of taxation.

To see why this deadweight loss occurs, look at the supply and demand curves in the graph below. When a market transaction is taxed, the buyer pays a higher price and the seller receives a lower price. This lowers demand, which shifts the buyer's equilibrium from the market price to a higher price; likewise, because the seller receives less for his product, less of it is supplied, which moves the seller's equilibrium down the supply curve, to a lower price. The amount that the government receives is equal to the tax, which is equal to the buyer's price minus the seller's price, times the quantity of the transaction, whether for goods or services.

Tax Revenue = Tax × Quantity

Supply-demand graph illustrating the deadweight loss of taxation on goods or services.

The area of the light red rectangle in the graph is equal to the tax revenue collected by the government. The area of the dark red triangle is equal to the economic welfare that is lost to taxation.

  • Pb = Price buyers pay.
  • Pm = Market price without taxes.
  • Ps = Price sellers receive.

This loss of economic welfare consists of buyers who will no longer buy the product because the price is higher than their willingness to pay price, so they decide to do without. Likewise, some sellers will not produce a product because they are not receiving a high enough price to cover their economic costs. The benefit that these buyers and sellers would have added to the economy but for the tax is a deadweight loss of taxation. Because these buyers and sellers do not participate in the market, they do not contribute to the tax. Instead, the taxes are paid by the buyers and sellers who continue to participate in the market. The buyers pay part of the tax in an economic sense through their reduced consumer surplus, which is the difference between their willingness-to-pay price and the product price. Likewise, sellers pay part of the tax to their reduction in producer surplus. This loss, however, goes to the government in the form of its tax, which makes sense, since only the buyers that continue to buy the product and the sellers who continue to sell the product contribute to the tax.

How Deadweight Loss Varies with Elasticity

The amount of the deadweight loss varies with both demand elasticity and supply elasticity. When either demand or supply is inelastic, then the deadweight loss of taxation is small, because the quantity bought or sold does not vary much with the price. With perfect inelasticity, there is no deadweight loss. However, deadweight loss increases proportionately to the elasticity of either supply or demand.

4 graphs showing how the deadweight of taxation and the tax burden on buyer and seller differs according to the elasticity of both demand and supply.

Who suffers the tax burden also depends on elasticity. When supply is inelastic or demand is elastic, then the seller suffers the major tax burden, as can be seen in the orange-shaded areas in graphs #2 and #4, above; when supply is elastic or demand is inelastic, then the buyer pays most of the tax (Graphs #1 and #3). Of course, the effect of elasticity on the tax is no different from its effect on any other price change.

Tax Revenue and Deadweight Loss

Tax revenue varies with the proportion of the tax as a percentage of the product price. In most cases, 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 little 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.

 2 graphs showing how tax revenue and deadweight loss varies with the proportion of the tax on goods or services.
Graph showing how the deadweight loss increases exponentially with the tax rate.

As can be seen from the graph on the left, 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.

Deadweight Loss of Taxation on Labor

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 1970s, Arthur Laffer argued that tax revenue can be increased by reducing the tax rate. He illustrated this with what has been called the Laffer curve, which shows the tax revenue generated as the tax rate increases from 0 to 100%.

Laffer curve for working income, showing how the tax revenue increases at first, then declines to zero as the tax rate approaches 100%.

He argued that tax revenue generated from labor increases at first, and then, at a certain point, it starts to decline until it reaches zero. In the 1980s, 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. Nonetheless, this view was adopted by Ronald Reagan when he was President of the United States. 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 makes sense to some extent, the supply of labor is relatively inelastic, since most everyone except for the wealthy have to work in order to survive. Hence, the tax burden on labor falls on labor. This is best evidenced by the fact that when Bill Clinton increased the tax rate, particularly on the wealthy, tax revenue increased proportionately. So the economy must have been before the maximum tax revenue point.

Deadweight Loss of Transaction Taxes, Value Added Taxes, and Property Taxes

Transaction taxes include taxes on buying and selling property, which includes sales and use taxes, excise taxes, and value-added taxes. Transaction taxes also incur a deadweight loss, since they increase the price for the buyer and decrease the money received by the seller.

Property taxes on raw land incur no deadweight loss because its supply is perfectly inelastic. However, there is some deadweight loss from property taxes on developed land since they may have an impact on development. More info on tax types: Types of Taxes

Deadweight Loss of Taxes on Investment Income

The Laffer curve on investment income would be similar to the curve on working income, in that, as the tax rate approaches 100%, tax revenue falls to zero. However, the supply of investments is also inelastic, because you can only do 3 things with money: spend it, keep it, or invest it. Poor people spend all of their money, but the wealthy have much more money than they can spend on life's necessities, or even its conveniences. If they keep it, then inflation diminishes its value. Furthermore, money has a time value which is forfeited if the money is not invested. Even if investment income was highly taxed, people would still invest because it does not require the time and effort that work requires. Indeed, the type of investment that requires the least amount of effort — long-term capital gains — is taxed the least.

Another reason that deadweight loss is lower on investment income than on working income is because higher taxes help to reduce the sting of losses. Taxes on investment income reduces the net income received, but it also reduces losses. For instance, suppose that investment income is taxed at 60%. You make 2 investments: one investment earns $100 during the tax year, but $50 is lost on the other investment. If you only had the one investment that gained $100, then you would receive a net of $40 after paying the 60% tax. But, combining the $50 loss with the $100 gain yields $50 of net taxable income, which, after paying the 60% tax on the net income, yields $30, which is only $10 less than if you had no losses at all. So taxes on investment income helps to mitigate losses, which offsets some of the deadweight loss of the tax.

There Is No Deadweight Loss from Gratuitous Transfer Taxes

On the other hand, what about gift, estate or inheritance taxes? These are often referred to as gratuitous transfer taxes because the beneficiaries do nothing to earn their gift. When a person dies, governments can either choose to tax the estate of the deceased person or tax the inheritance that the beneficiaries receive, or a combination of both, or neither. Because death is inevitable and because beneficiaries do nothing to earn their inheritance, no deadweight loss arises from either estate taxes or inheritance taxes (collectively known as death taxes). Likewise, for gifts.

Laffer curve for gratuitous transfers, showing how the tax revenue collected increases proportionately with the tax rate.

Elasticity of supply and demand is usually discussed with respect to prices. Property transferred gratuitously, by definition, has no price, so elasticity in regard to the supply and demand for gratuitous property must be measured in regard to the tax itself.

That there is no deadweight loss from taxes on gratuitous transfers can also be seen by the fact that the supply of gratuitous property is perfectly inelastic – even if the death tax is 100%, people will continue to die at the same rate. For gift taxes, under federal tax law, demand is also perfectly inelastic, since the beneficiaries pay nothing for the gift (in the United States, the donor pays the gift tax – not the donee). Therefore, beneficiaries will take whatever is given to them. Although gift taxes, whether they are assessed on the donor or the donee, may reduce the number or value of gifts given, this has no economic consequence, since gifts are freely given. Moreover, since everyone will have to part with their property either while they are alive or when they are dead, all of their property will either be a gift or it will eventually become a bequest — hence, there is no deadweight loss from gratuitous transfer taxes. The deadweight loss of gratuitous transfer taxes is zero — tax revenue increases proportionately with the tax rate, as can be seen from the graph of the Laffer curve for gratuitous transfer taxes.

Why Earned Income — Income Earned from Work — Is the Most Heavily Taxed Form of Income

So if there is a large deadweight loss from income taxes on work, but no deadweight loss from gratuitous transfer taxes, why is working income the most heavily taxed form of income while gratuitous transfers are taxed the least? Because gratuitous transfers benefit mostly the wealthy, allowing them to increase their wealth from generation to generation, part of which is used to influence politicians to maintain the status quo. Moreover, most politicians are also wealthy. Since many politicians come from wealthy families, they receive a great deal of wealth as beneficiaries, and most have a great deal to pass on, since they often become wealthier while holding office. So politicians have a vested interest in keeping gratuitous transfer taxes low, or even eliminating them entirely, as the Republicans want to do.