The Deadweight Loss From Taxes: Anti-Taxers Don’t Care

November 9th, 2010

Anti-tax zealots are wont to point to the problem of “deadweight loss” when trying to demonstrate how awful taxes are. The rule/theory of deadweight loss says that a tax in general makes us all worse off than we would be without taxes, because a certain amount of production and value simply disappears as a result of taxation. (This ignores the additional production and value that government spending can engender — something that deadweight-lossers tend gloss over — and that taxation is necessary if governments are going to spend. But that’s another subject.)

I won’t explain the details of deadweight loss here; you can visit the wikipedia link above, and go from there. But I will say that it’s a real issue, and something that bears serious consideration in deciding what to tax, and how much.

It’s not the only consideration, of course — there are many others, having to do with both economic efficiency and equity — but with its rather apocalyptic name, it’s the one that anti-taxers like to trot out all on its lonesome as some kind of unabrogatable argument.

What’s curious, though, is that those anti-taxers — supposedly so deeply steeped in supply and demand curves — don’t consider deadweight loss when trying to decide what to tax, and how much.

There’s a solid rule of thumb on this subject: taxing things with “high demand elasticity” results in greater deadweight loss. In plain English: if people are likely to stop consuming a good — to substitute something else — because a tax makes the good more expensive, you’ll get more deadweight loss. This is an argument, as an example, for avoiding taxes on purchases of luxury goods, because there are good substitutes for luxury goods: buying a Timex instead of a Rolex, or just saving the money instead of spending it. Since luxury goods are not really crucial to life, if you tax them people are quite likely to buy less of them, and the result is deadweight loss.*

So with this rule of thumb, let’s look at different taxes:

• Which ones have high demand elasticity, hence (ceteris paribus) high deadweight loss?

• Which ones do the anti-taxers hate the most, and most want to eradicate?

Income taxes. If you tax income, will people switch to something else? There’s a damned good substitute: leisure. This argues against taxing high-income people (especially with progressively higher marginal rates), because it’s easier for them to choose leisure over work. But most people — given our tax levels — will just try to earn as much as they can. For folks who are trying to support a family and get ahead, there’s not much elasticity of demand for income; they just want more. There are important exceptions — a notable one being mothers considering getting a job. Their time with their kids is extremely valuable to them (I can relate!), so even relatively low taxes could discourage them from entering the workforce. Deadweight loss. Anti-taxers are pretty ideologically consistent here; they generally argue for some kind of flat tax, or increases in regressive taxes like the payroll tax, which would in theory result in lower deadweight losses.

Consumption taxes (including sales taxes, value-added taxes, and the widely bruited federal consumption tax). People have a great deal of discretion over their spending, at least once the essentials are covered. If all we cared about was deadweight loss, we’d only tax the essentials — food, clothing, shelter, health care, etc. — because they’re necessary and there are no substitutes, so there’s little demand elasticity. But in fact we do the opposite — excluding food and rent from sales taxes, for instance — for reasons having nothing to do with deadweight loss that are both obvious and valid (economically and ethically). Since we have little choice but to do that, consumption taxes (inherently subject to deadweight loss in the first place because consumers have direct control over their spending) inevitably fall on goods with higher demand elasticity, hence higher deadweight losses. Despite this fact, the anti-tax crowd loves consumption taxes. Go figger.

Taxes on investment income. There’s superficially sensible but ridiculous notion, widely promulgated, that taxing investment reduces investment — just like any other taxed “good.” It’s ridiculous because unlike most other goods, there is no substitute for investment. If you have money, the only alternative to investment is money in a mattress — which isn’t any kind of alternative (except in rare periods of deflation), because inflation makes it disappear. If you want to make money on your money, you have to invest it. So taxes on investment income, with its low demand elasticity, should have very low deadweight losses. But — surprise — the anti-taxers consistently push for lower (or no) taxes on investment income. (Note that by “investment” here, I’m talking about financial investments, which in theory are funneled into actual productive investments in plants, property, equipment, software, training, etc. through the intermediation of the financial markets.)

Property taxes. There’s an important distinction here: between taxes on land and taxes on improvements (houses, buildings, gardens, water parks). Economists have long pointed out that land taxes, once implemented, result in little or no deadweight loss. Taxes on improvements are otherwise, because they encourages land owners to spend money on things other than improvements, and there are substitutes. So what to make of the widespread state-level resistance to property taxes? To the extent that they tax improvements, that resistance makes sense from a deadweight-loss perspective. To the extent that they tax land values, it doesn’t — quite the contrary. Mixed bag here.

Wealth taxes. There is no substitute for being wealthy. Nobody will avoid it and choose something else if it’s taxed, because the only alternative is … not being wealthy. (Don’t confute this with the income that generates wealth over time; we already discussed that. One is a state; the other is a flow.) Anti-taxers obsessed with deadweight loss should love taxes on wealth (if you can get them to admit that something’s gotta be taxed). Now, straightforward taxes on peoples’ total net worth don’t really exist, because they’re impracticable. Are people going to have their houses, businesses, horses, boats, stamp collections, and cars appraised every year, and submit the appraisals(s) to the IRS? Not gonna work. (And taxing only financial wealth is distortionary, because people can shift to other investments like real estate or art.) But there is one tax on wealth that is eminently practicable, that currently exists, and that the anti-taxers despise with all their hearts:

Estate taxes. If you care about deadweight loss, this is the tax for you. There’s only one substitute for giving your money to your kids: giving it to charity. I’d be interested to hear an argument that this results in deadweight loss. I’d be even more interested to see analytics demonstrating that — even with some presumed quantity of deadweight loss included — it results in lower national prosperity over the decades. There are many economic cycles and epicycles to consider there, extending far beyond the supply and demand curves for estates, and the presumed deadweight loss that might result.

I think all this makes one thing perfectly clear: anti-taxers’ rants about deadweight losses aren’t about improving the economic efficiency of the tax system. They’re simply rhetorical ploys, cherry-picking one tiny area of economic thinking (and that only when it serves their turns), to protect their own wealth. (Low-income Joe-the-Plumbers who ignorantly trot out vague notions of deadweight loss are just dupes who — largely for egotistical reasons — have fallen for the multi-decade, multi-hundred-billion-dollar propaganda campaign funded by that concentrated wealth, brilliantly engineered to convince them that it’s the poor people and furriners who are taking all their money.)

Again, deadweight loss is far from the only consideration in designing an efficient and equitable tax system. This just to point out the hypocrisy of anti-taxers screaming about deadweight loss when it serves their wild-eyed rhetorical turns, but ignoring it when it comes to actual recommendations for tax policy. (Even worse, actually: they invoke it when they’re talking about income taxes, but ignore it when they’re talking about all the others.)

* Anti-taxers love to point to the early-90s luxury tax on yachts — and the resulting crash in the yacht building industry — as an example. What they don’t mention is that 1) the tax was only on domestically produced yachts, and 2) the tax was instituted at the same time as a recession, and a significant decline in East-Coast real-estate values (which, not surprisingly, correlate very tightly with yacht purchases). The resulting sales decline only demonstrates that it’s stupid to tax domestic goods and not tax their immediately-available imported substitutes — not that it’s stupid to tax luxury goods. (Though it may be, that instance doesn’t prove it.)

Comments are closed.