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In
economics Economics () is the social science that studies the production, distribution, and consumption of goods and services. Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics anal ...
, the excess burden of
taxation A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, o ...
, 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 Economics () is the social science that studies the production, distribution, and consumption of goods and services. Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics analyze ...
posits that
distortions In signal processing, distortion is the alteration of the original shape (or other characteristic) of a signal. In communications and electronics it means the alteration of the waveform of an information-bearing signal, such as an audio signal ...
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 (MCF). Excess burdens were first discussed by
Adam Smith Adam Smith (baptized 1723 – 17 July 1790) was a Scottish economist and philosopher who was a pioneer in the thinking of political economy and key figure during the Scottish Enlightenment. Seen by some as "The Father of Economics"——� ...
. An equivalent kind of inefficiency can also be caused by subsidies (which technically can be viewed as taxes with negative rates). Economic losses due to taxes have been evaluated to be as low as 2.5 cents per dollar of revenue, and as high as 30 cents per dollar of revenue (on average), 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 (MCF) is the size of the distortion that accompanied the last unit of revenue raised (i.e. the rate of change of distortion with respect to revenue). In most cases, the MCF increases as the amount of tax collected increases. A common 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 A progressive tax is a tax in which the tax rate increases as the taxable amount increases.Sommerfeld, Ray M., Silvia A. Madeo, Kenneth E. Anderson, Betty R. Jackson (1992), ''Concepts of Taxation'', Dryden Press: Fort Worth, TX The term ''progre ...
, 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.Ostry Jonathan, Berg Andrew, Tsangarides Charalambos. “Redistribution, Inequality, and Growth”. Staff Discussion Notes No. 14/02, International Monetary Fund, February 2014 In fact almost any tax measure will distort the economy from the path or process that would have prevailed in its absence ( land value taxes are a notable exception together with other capital or
wealth tax A wealth tax (also called a capital tax or equity tax) is a tax on an entity's holdings of assets. This includes the total value of personal assets, including cash, bank deposits, real estate, assets in insurance and pension plans, ownershi ...
es). For example, a
sales tax A sales tax is a tax paid to a governing body for the sales of certain goods and services. Usually laws allow the seller to collect funds for the tax from the consumer at the point of purchase. When a tax on goods or services is paid to a gove ...
applied to all goods will tend to discourage consumption of all the taxed items, and an
income tax An income tax is a tax imposed on individuals or entities (taxpayers) in respect of the income or profits earned by them (commonly called taxable income). Income tax generally is computed as the product of a tax rate times the taxable income. Ta ...
will tend to discourage people from earning money in the category of income that is taxed (unless they can manage to avoid being taxed). Some people may move out of the work force (to avoid income tax); some may move into the cash or black economies (where incomes are not revealed to the tax authorities). 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 (and associated subsidies to the poor), incentives are changed for both groups. The relatively rich are discouraged from declaring income and from earning marginal (extra) 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 (and usually their assets) so as to increase the likelihood of their receiving state assistance (
welfare trap The welfare trap (or unemployment trap or poverty trap in British English) theory asserts that taxation and welfare systems can jointly contribute to keep people on social insurance because the withdrawal of means-tested benefits that comes wi ...
). 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 (e.g. encouraging the growth of company car fleets). 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

Pigovian taxes create distortions intended to correct for
externalities In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either c ...
and produce 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 Alcohol most commonly refers to: * Alcohol (chemistry), an organic compound in which a hydroxyl group is bound to a carbon atom * Alcohol (drug), an intoxicant found in alcoholic drinks Alcohol may also refer to: Chemicals * Ethanol, one of sev ...
,
tobacco Tobacco is the common name of several plants in the genus '' Nicotiana'' of the family Solanaceae, and the general term for any product prepared from the cured leaves of these plants. More than 70 species of tobacco are known, but the ...
and
pollution Pollution is the introduction of contaminants into the natural environment that cause adverse change. Pollution can take the form of any substance (solid, liquid, or gas) or energy (such as radioactivity, heat, sound, or light). Pollutants, th ...
. 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 Prohibition is the act or practice of forbidding something by law; more particularly the term refers to the banning of the manufacture, storage (whether in barrels or in bottles), transportation, sale, possession, and consumption of alcoholi ...
, since prohibition incites trafficking, often resulting in
crime In ordinary language, a crime is an unlawful act punishable by a state or other authority. The term ''crime'' does not, in modern criminal law, have any simple and universally accepted definition,Farmer, Lindsay: "Crime, definitions of", in C ...
and other social costs, but no tax revenue.


See also

* Effect of taxes and subsidies on price *
Laffer curve In economics, the Laffer curve illustrates a theoretical relationship between rates of taxation and the resulting levels of the government's tax revenue. The Laffer curve assumes that no tax revenue is raised at the extreme tax rates of 0% and ...
* Land value tax *
Lump-sum tax A lump-sum tax is a special way of taxation, based on a fixed amount, rather than on the real circumstance of the taxed entity.
* Optimal tax *
Tax incidence In economics, tax incidence or tax burden is the effect of a particular tax on the distribution of economic welfare. Economists distinguish between the entities who ultimately bear the tax burden and those on whom tax is initially imposed. The ta ...


References

* Bayer, R. C., & Sutter, M. (2009)
The excess burden of tax evasion—An experimental detection–concealment contest
''European Economic Review'',''53''(5), 527-543. * T.N. Srinivasan (1987). "distortions," '' The New Palgrave: A Dictionary of Economics'', v. 1, pp. 865–67. * N.H. Stern (1987). "optimal taxation," '' The New Palgrave: A Dictionary of Economics'', v. 1, pp. 865–67. {{Unintended consequences Welfare economics Tax incidence Theory of taxation