Taxes and Efficiency

The US government at various levels raises and spends money, let’s consider how one might evaluate its tax policy. Obviously purpose of tax system is to raise revenue for the government. But there are many ways to raise any given amount of money. In designing a tax system policymakers have two objectives efficiency and equity.

One tax system is more efficient than another if it raises the same amount of revenue at smaller cost to taxpayers. What are the costs of taxes to taxpayers? The most obvious cost is the tax payment itself. This transfer of money from the taxpayers to the government is an evitable feature of any tax system. Yet taxes also impose two other costs, which a well-designed tax policy tries to avoid or at least minimize.

1) The deadweight losses that result when taxes distort the decisions that people make:
2) The administration burden that taxpayers bear as they comply with the tax laws.

An efficient tax system is one that imposes small deadweight losses and small administrative burdens.

Deadweight losses:

One of the principles of Economics is that people respond to incentives and this includes incentives provided by the tax systems. If the government taxes ice cream, people eat less ice cream and more frozen yogurt. If the government taxes housing people live in smaller houses and send more of their income on other things. If the government taxes labor earnings, people work less and enjoy more leisure.

Because taxes distort incentives they entail deadweight losses. As we first discussed the deadweight loss on a tax is the reduction in economic well-being of taxpayers in excess of the amount of revenue raised by the government. The dead weight loss is the inefficiency that a tax creates as people allocate resource according the tax incentive rather than the true cost and benefits of the goods and service that they buy and sell.

To recall how taxes cause deadweight losses, consider an example. Suppose that Joe places an $8 value on a pizza, and Jane places a $6 value on it. If there is no tax on pizza, the price of pizza will reflect the cost of making it. Let’s suppose that their price of pizza is $5 so both Joe and Jane choose to buy one. Both consumers of $3, and Jane gets consumer surplus of $1. Total surplus is $4.

Now suppose that the government levies a $2 tax on pizza and the price of pizza rises to $7. Joe still buys pizza but now he has consumers’ surplus of only $1. Jane now decides not to buy a pizza because its price is higher than its value to her. The government collects tax revenues of $2 on Joe‘s pizza. Total consumer surplus has fallen by $3 (from $4 to $1) because total surplus has fallen by more than the tax has a deadweight loss. In this case the deadweight loss is $1.

Notice that the deadweight loss comes not from Joe, the person who pays the tax but from Jane, the person who doesn’t. The reduction of $2 in Joe’s surplus exactly offsets the amount of revenue the government collects. The deadweight loss arises because the tax causes Jane to alter her behavior. When the tax raises price of pizza, Jane is worse of, and yet there is on off setting the revenue to the government. This reduction in Jane’s welfare is the deadweight loss of the tax.
Source: Principles of Economics