In economics, the excess burden of taxation, also known as the deadweight cost or deadweight loss of taxation, is one of the economic losses that society suffers as the result of taxes or subsidies. Economic theory posits that distortions change the amount and type of economic behavior from that which would occur in a free market without the tax. Excess burdens can be measured using the average cost of funds or the marginal cost of funds. Excess burdens were first discussed by Adam Smith. An equivalent kind of inefficiency can also be caused by subsidies. Economic losses due to taxes were evaluated to be as low as 2.5 cents per dollar of revenue, and as high as 30 cents per dollar of revenue, and even much higher at the margins.
Measures of the excess burden
The cost of a distortion is usually measured as the amount that would have to be paid to the people affected by its supply, the greater the excess burden. The second is the tax rate: as a general rule, the excess burden of a tax increases with the square of the tax rate. The average cost of funds is the total cost of distortions divided by the total revenue collected by a government. In contrast, the marginal cost of funds is the size of the distortion that accompanied the last unit of revenue raised. In most cases, the MCF increases as the amount of tax collected increases. The standard position in economics is that the costs in a cost-benefit analysis for any tax-funded project should be increased according to the marginal cost of funds, because that is close to the deadweight loss that will be experienced if the project is added to the budget, or to the deadweight loss removed if the project is removed from the budget.
Distortion and redistribution
In the case of progressive taxes, the distortionary effects of a tax may be accompanied by other benefits: the redistribution of dollars from wealthier people to poorer people who could possibly obtain more benefit from them - in effect reducing economic inequalities and improving GDP growth. In fact almost any tax measure will distort the economy from the path or process that would have prevailed in its absence. For example, a sales tax applied to all goods will tend to discourage consumption of all the taxed items, and an income tax will tend to discourage people from earning money in the category of income that is taxed. Some people may move out of the work force ; some may move into the cash or black economies. For example, in Western nations the incomes of the relatively affluent are taxed partly to provide the money used to assist the relatively poor. As a result of the taxes, incentives are changed for both groups. The relatively rich are discouraged from declaring income and from earning marginal income, because they know that any additional money that they earn and declare will be taxed at their highest marginal tax rates. At the same time the poor have an incentive to conceal their own taxable income so as to increase the likelihood of their receiving state assistance. It can be argued that the distortion of incentives does more harm than good. There was an example of distortion of the economy by tax policy some years ago in the UK when cars supplied by employers to their employees were taxed at advantageous rates. Over several years the distortion grew to the point that the majority of cars used by working families were company cars and the dealership structures, and even the types of cars used, altered to adjust to the tax regime.
Deliberate distortion
Not all distortions are bad; Pigovian taxes create distortions that correct for externalities and therefore have a negative MCF. Here, the fiscal distortion is deliberate, so as to compensate for externalities. "Sin taxes" are levied on products that incur additional costs to society, such as alcohol, tobacco and pollution. Ideally, these taxes raise the price to the exact level that the market would bear if the negative externalities were included in the price. Pigovian taxes are often preferable to outright prohibition, since prohibition incites trafficking, often resulting in crime and other social costs, but no revenue.
