Deadweight Loss of Taxation
The most 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 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 exceeds the gain to the government. Therefore, the economy as a whole loses some value from taxation, a complete loss called the deadweight loss of taxation. Specifically, deadweight loss consists of the loss of consumer surplus for buyers + the loss of producer surplus for sellers who do not participate in the market for reasons other than the price of the product or service, resulting in less total surplus for the economy. Deadweight losses can also be created by artificial barriers to competition, such as occupational licensing requirements, or from the artificial restriction of supply by monopolists or oligopolists.
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 (Pm) to a higher price (Pb) at lower quantities; likewise, because the seller receives a lower price (Ps) for his product, less of it is supplied, which moves the seller's equilibrium down the supply curve, to a lower price and quantity. The amount the government receives equals the tax, which equals the buyer's price minus the seller's price, times the quantity of the transaction, whether for goods or services.
Tax Revenue = Tax × Quantity
The area of the light purple rectangle in the graph equals the tax revenue collected by the government. The area of the dark purple triangle equals the economic welfare lost to taxation.
- Pb = Price buyers pay. Demand is reduced because buyers must pay a higher price because of the tax.
- Pm = Market price without taxes.
- Ps = Price sellers receive.
- Qe = The quantity supplied without the tax.
- Qt = The reduced quantity supplied because of the tax.
This loss of economic welfare consists of buyers who will no longer buy the product because the price exceeds their willingness-to-pay price, so they 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, which is why the government does not receive the portion consisting of the deadweight loss. 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, as a reduction in their consumer surplus, which is the difference between their willingness-to-pay price and the product price. Likewise, sellers pay part of the tax as a reduction in their producer surplus. This loss, however, goes to the government as a tax, which makes sense, since only the buyers who continue to buy the product and the sellers who continue to sell the product contribute to the tax. Thus, in terms of total surplus (= consumer surplus + producer surplus), the deadweight loss = the reduction in total surplus minus the tax revenue collected by the government.
Deadweight Loss = Loss of Total Surplus − Tax Revenue
How Deadweight Loss Varies with Elasticity
The amount of deadweight loss varies with both demand elasticity and supply elasticity. When either demand or supply is inelastic, then the deadweight loss of taxation is smaller, because the quantity bought or sold varies less with price. With perfect inelasticity, there is no deadweight loss. However, deadweight loss increases proportionately to the elasticity of either supply or demand.
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. 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 greatly exceeds 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 is more detrimental to the economy, since it reduces total surplus more: fewer people can 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 declines as a decreasing quantity more than offsets the increasing 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%.
He argued that tax revenue generated from labor increases at first, but then, after a certain point, it declines until it reaches zero. In the 1980s, the Republicans argued this would 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 was called supply-side economics, because lower taxes increase the supply of everything, but especially labor.
While the above argument 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. 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, including 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 impact development. More info on tax types: Types of Taxes
Deadweight Loss of Taxes on Investment Income
The Laffer curve on investment income would follow 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 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 requiring the least effort — long-term capital gains — is taxed the least.
Another reason deadweight loss is lower on investment income than on working income is because higher taxes help reduce the sting of losses. Taxes on investment income reduces the net income receive but also reduces losses. For instance, suppose 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 help mitigate losses, which offsets some of the deadweight loss of the tax.
No Deadweight Loss from Gratuitous Transfer Taxes
On the other hand, what about gift, estate or inheritance taxes, called 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 called death taxes). Likewise, for gifts.
Elasticity of supply and demand is usually discussed with respect to prices. Property transferred gratuitously, by definition, has no price, so elasticity of the supply and demand for gratuitous property must be measured regarding 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 must part with their property either while they are alive or when they are dead, all their property will either be a gift or a bequest — hence, there is no deadweight loss from gratuitous transfer taxes.
Why Earned Income — Income Earned from Work — Is the Most Heavily Taxed Form of Income
In the United States, gratuitous transfers are taxed by the federal government, but that same government provides a unified tax credit that taxpayers can use to offset these taxes, allowing parents, for instance, to pass about $27.2 million (as of 2024) to their children tax-free, an amount increases annually, since the unified tax credit is indexed to inflation. This amount greatly exceeds what most American workers will earn in their entire lives.
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? Where is the unified tax credit for labor?
The answer is because gratuitous transfers benefit mostly the wealthy, allowing them to increase their wealth from generation to generation, some of that 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. Furthermore, people who work must pay higher taxes to make up for the revenue shortfall created by the unified tax credit.
Note: The Republicans did try to eliminate gratuitous transfer taxes in their latest tax reform for the wealthy, the Tax Cuts and Jobs Act, but they could not eliminate these taxes without exploding the deficit even more than they already have.
Deadweight Loss from Imperfect Competition
Deadweight loss also arises from imperfect competition, especially from oligopolies and monopolies. This deadweight loss arises because these firms restrict supply to increase prices over and above average total costs. The higher prices will still restrict some consumers from enjoying the product, and as with the deadweight loss of taxation, it will reduce the consumer surplus of the remaining buyers, but the restricted supply allows these firms to enjoy economic profits, profits that exceed the normal profits included in average total costs. However, the additional revenue from the higher prices goes not to the government as taxes, but to the price-setting firms as additional producer surplus.