Supply, demand, elasticity deadweight loss –all this economic theory is enough to make your head spin. But believe it or not, these ideas go to the heart of a profound political question: How big should the governments be? The debate hinges on these concepts because the larger the deadweight loss of taxation the larger to cost of any government program. If taxation entails large deadweight losses then losses area is a strong argument for leaner governments that does less and taxes less. But of taxes impose small deadweight losses, and then government programs are less costly than they otherwise might be.
So how big are the deadweight losses of taxation? These as question about which economists disagree to see the nature of these agreements consider the most important tax in the US economy: the tax on labor. The Social Security tax the Medicare and to a large extent the federal income taxes. Many state governments also tax labor earnings. A labor tax places a wedge between wages that firms pay and the wages that workers receive. If we add all forms of labor taxes together the marginal tax rate on labor income – the tax on the last dollar of earnings is almost 50 percent for many workers.
Although the size of the labor tax is easy to determine the deadweight loss of this tax is less straightforward. Economics disagree about whether this 50 per cent labor tax has a small or a large deadweight loss. This disagreement arises because economists hold different views about the elasticity of labor supply.
Economists who argue that labor taxes do not greatly distort market outcomes believe that labor supply is fairly inelastic. Most people they claim would word full time regardless of the wage, if so, the labor supply curve is almost vertical and a tax on labor has a small deadweight loss.
Economists who argue that labor taxes are highly distorting believe that labor supply is more elastic. They admit that some groups of workers may supply their labor inelasticity but that claim many other groups respond move to incentives. Here are some examples
Many workers can adjust the number of hours they work – for instance by working overtime. The higher the wage the more hours they choose to work.
Some families have second earners – often married women with children with some discretion over whether to do unpaid work at house or paid work in the marketplace. When deciding whether to take a job, these second earners compare the benefits of being to home (including savings) on the cost of child care) with the wages they could earn.
Many of the elderly can choose when they retire and their decisions are partly based on the wage. Once they are retired the wage determines their incentive to work part time.
Some people consider engaging in illegal economic activity such as the drug trade, or working at jobs that pay under the table to evade taxes. Economists call this the underground economy. In deciding whether to work in the underground economy or at a legitimate job, these potential criminals compare what they can earn by breaking the law with the wage they can earn legally.
In each of these cases the quantity of labor supplied responds to the wage (the price of labor).Thus, the decisions of these workers are distorted when their labor earnings are taxed. Labor taxes encourage workers to work fewer hours second earners to stay at home, the elderly to retire early and the unscrupulous to enter the underground economy.
These two views of labor taxation persist to this day. Indeed, whenever you see two political candidates debating whether the government should provide more services or reduce the tax burden keep in mind that part of the disagreement may rest in different views about the elasticity of labor supply and the deadweight loss of taxation.