How Taxes Affect Deadweight Loss?

Cause

Deadweight loss is the loss in social surplus that occurs when a market produces an inefficient quantity (Hall and Lieberman 454). In other words, a deadweight loss can be characterized as the costs that the market’s inefficiency imposes on society. A deadweight loss might be applied to any deficiency that an ineffective resource allocation provokes. Therefore, deadweight loss appears in case demand and supply are unbalanced.

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To understand the cause of a deadweight loss, it is necessary to consider the process on the whole. Thus, the biggest part of the revenue that the government receives comes from the taxation of market transactions, particularly from the labor taxes. The taxes essentially bring down the value of transactions for buyers and sellers. Therefore, buyers pay more money for products, and suppliers get less money. The government receives a particular part of that loss of value it is the principal reason for the government to collect taxes. Nevertheless, the loss of value to buyers and suppliers is still larger than the gain of the government. As a result, the economy generally loses a certain value from taxation- the amount of this loss is called the deadweight loss (Hall and Lieberman 455).

Thus, the key ideas one should understand about the deadweight cause might be put as follows:

  • Deadweight loss is the cost market’s inefficiency imposes on society.
  • Deadweight loss occurs when demand and supply are unbalanced.
  • The size of the deadweight loss is equal to the size of value that the economic losses from taxation.

Taxes as Determinants of Deadweight Loss

As long as the cause of the deadweight is clarified, it is critical to identify the factors that determine the size of the deadweight loss. In other words, it is important to understand why a deadweight loss is large in some cases and small in others.

On the face of it, the size of the deadweight loss depends on the size of the tax. Assuming that all other aspects are relatively constant, we find the relevant interconnection – the bigger the tax, the bigger the deadweight loss. Some specialists note that the deadweight loss tends to increase more rapidly than the tax itself. The might be explained by the fact that whereas the tax and the deadweight loss are in such interconnection that whereas the tax doubles, the deadweight loss increases by a factor of 4. In case the tax triples, the size of the deadweight loss increases, consequently by a factor of 9.

It is also important to take into account the tax revenue that is the size of “the tax times the amount of the good sold”. Imposing small taxes means receiving small tax revenues and vice versa. In the meantime, an excessively large tax is likely to bring no revenues at all as the consumers can drop both buying and selling. Therefore, one might represent the following patterns of relations between taxes and deadweight loss:

  • Low taxes – low deadweight loss
  • High taxes – high deadweight loss
  • Excessively high taxes – low revenues – excessively high deadweight loss

Another key determinant of the deadweight loss’s size is the elasticity of the prices of demand and supply (Mankiw 160). On the whole, the deadweight loss increases on the condition that the market gets more elastic and sensitive to the shift in price. This phenomenon might be explained by the fact that elastic markets are more likely to face significant quantity drops due to the tax introduction.

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As a result, there two principal determinants of the deadweight loss’s size:

  • The size of the tax
  • The elasticity of the market

Challenges

The previous part explained how the size of a deadweight loss is determined. An accurate evaluation of this size is critical for the government as the cost of any governmental program depends on the deadweight loss – the larger is the latter, the larger is the former. In the framework of the US economy, the principal challenge is to evaluate the deadweight loss from the tax on labor. This tax is comprised of the following taxes:

  • The Social Security Tax
  • The Medicare tax, etc.

It is easy to assess the size of the tax itself, whereas, the evaluation of the deadweight loss is more problematic. There are two opposite opinions regarding the determination of the deadweight loss in the tax on labor:

  • Some economists believe that the labor market is generally inelastic. They explain it by the fact that the majority of people are ready to supply a particular amount of labor regardless of the size of the wages they receive (Mankiw 162). Therefore, according to this point of view, the deadweight loss on the tax on labor is relatively small.
  • Other specialists assume that the labor supply market is rather elastic. They suppose that particular groups in the labor market are highly sensitive to the changes in wages. Thus, some people are enabled to regulate the amount of time they work following the amount of money they earn (Mankiw 163). Therefore, according to this point of view, the deadweight from the tax on labor is rather high.

As may be seen from both the theories, all the specialists base their assumptions on the elasticity criteria, which means that it is an important determinant of the size of the deadweight loss.

Deadweight Loss in the Framework of Economic Principles

The evaluation of the deadweight loss’s size is important as it has a strong connotation for several economic principles. First, of all, it’s Principle 7 that says that “People Face Trade-Offs (Mankiw and Taylor 25). According to this principle, every choice that a person makes, whether it is related to money or time issues, essentially has some implications for trade-offs. One of the most widespread examples illustrating trade-off terms the choice between efficiency and equality. While efficiency implies increasing the values of the resources, equality means an equal spread of these resources among people. Therefore, in our case, when the government decides to redistribute labor taxes to finance unemployment it chooses equality instead of efficiency.

Another principle that might be applied to receive a better idea of the way the tax affects deadweight loss is Principle 3 that says that “Rational People Think at the Margin”. This principle is based on the presumption that people perform decision making rationally (Mankiw and Taylor 26). In other words, they make choices pursuing a particular purpose to achieve a certain aim. Thus, people perform decisions making based on their interests.

All the economic decisions are, likewise, made rationally. For example, agents perform decision making based on a thorough comparison of the potential marginal benefit and the possible marginal cost of this decision. In this case, taxes comprise a part of the marginal cost, and the size of the deadweight loss might be either positive or negative from the standpoint of the marginal benefit.

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Thus, we might consider the role of taxes and deadweight loss, in the framework of, at least, two economic principles:

  • Principle 1: People Face Trade-Offs
  • Principle 3: Rational People Think at the Margin

The impact of taxes and deadweight loss can be, likewise, regarded in the framework of the other eight principles.

Works Cited

Hall, Robert, and Marc Lieberman. Microeconomics: Principles and Applications. (Pages 449-460) Stamford, Connecticut: Cengage Learning, 2012. Print.

Mankiw, Gregory, and Mark Taylor. Economics. (Page 4-30) Stamford, Connecticut: Cengage Learning, 2006. Print.

Mankiw, Gregory. Principles of Macroeconomics. (Pages 160-171) Stamford, Connecticut: Cengage Learning, 2014. Print.

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StudyCorgi. (2021, May 8). How Taxes Affect Deadweight Loss? Retrieved from https://studycorgi.com/how-taxes-affect-deadweight-loss/

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StudyCorgi. 2021. "How Taxes Affect Deadweight Loss?" May 8, 2021. https://studycorgi.com/how-taxes-affect-deadweight-loss/.

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StudyCorgi. (2021) 'How Taxes Affect Deadweight Loss'. 8 May.

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