HENDERSON: Taxes Cause Deadweight Loss

By David R. Henderson
 
Economists often come up with clunky terms that are hard for non-economists to understand. But every once in a while they come up with terms that beautifully evoke the point they're trying to make. An example of the latter is “deadweight loss,” especially as it relates to taxation. A deadweight loss is a loss to some that is not offset by a gain to anyone.
 
Here’s an example. Imagine there is no tax on avocadoes. Every month I buy 10 avocadoes at $2.00 a piece. Then the government imposes a 50-cent tax on avocados. Imagine that the burden of the tax is shared equally by the consumer (me) and the producer. So I pay $2.25 for avocadoes and the producer nets $1.75 after tax.
 
Notice that the tax has put a 50-cent wedge between the price that I, the consumer, pay and the price net of tax that the producer receives. The result is a diminished incentive to produce and a diminished incentive to consume.
 
Let’s say that the net effect is that I now buy eight avocadoes per month, a reduction of two. The government collects $4.00 in tax revenue (eight times 50 cents.) My share of the tax revenue is $2.00 (eight times the extra 25 cents I pay.) The producer’s share of the tax revenue is $2.00 (eight times the 25 cents per avocado that he pays.)
 
That looks like a wash, right? Together the producer and I pay $4.00 and the government collects $4.00.
 
It’s not a wash. Why? Deadweight loss. Before there was a tax, I bought two extra avocadoes per month. And now I don’t buy them. I valued each of those two avocadoes at somewhere between $2.25 and $2.00. That’s why I would have bought them at $2.00 and won’t buy them at $2.25. The producer was willing to produce them for an amount between $1.75 and $2.00. But because I don’t buy them and he doesn't produce them, we each lose on the two avocadoes I would have bought and he would have produced.
 
Economists have actually estimated the deadweight loss from various taxes. Some taxes cause as much as 30 cents of deadweight loss per dollar collected. And that doesn’t even take account of the cost of collection. Tax officials, after all, insist on being paid and governments pay for offices to house them.
 
So when economists look at taxes, they don't, if they’re good economists, look only at the revenue a tax raises. They also look at the deadweight loss from taxes. And that can be substantial.

Today's TaxByte was written by David R. Henderson, a research fellow with the Hoover Institution at Stanford University.