Why Taxes Matter

Read the full report | It is known that taxpayers respond to tax incentives and disincentives. For example, a taxpayer may buy a larger house than they may “need” because they can deduct the mortgage interest from their income taxes. Since the behavior is tax-induced, it harms the economy. Rather than buying a larger house, the taxpayer could have instead invested in Google.

“Deadweight loss” is a term used by economists to describe the economic inefficiencies created by taxation such as when taxpayers reduce work and/or consumption or shift income in order to avoid taxation. In other words, the very process of transferring resources from the private to the government sector results in a permanent loss of potential economic output.

Chart 1 shows graphically how economists are able to estimate deadweight losses where Quantity (Qe) and Price (Pe) show the market equilibrium. The addition of tax has the same effect as an artificial price increase. The new price point of intersection with the Demand (P+Td) and Supply (P+Ts) curves is at Quantity (Qt). The rectangle formed by the new intersection is the revenue gained by the tax. However, the triangle represents the value of trade that would have occurred without the tax, but are not precluded by the tax. Deadweight loss can be estimated by calculating the area of the triangle.

However, estimating the deadweight loss is subject to the degree in which taxpayer’s change their behavior. If, in fact, taxpayers buy larger houses because the mortgage interest is deductible; then the deadweight loss is large and vice-versa. Economists refer to this as the “tax elasticity (TI).” The example given above is an example of “high tax elasticity.” Graphically, in Chart 1, TI is shown by the steepness and curvature of the supply and demand curves.

Based on this standard economic methodology, Dr. Martin Feldstein, president and CEO of the National Bureau of Economic Research, pioneered the empirical estimations of deadweight loss. In one of Dr. Feldstein’s famous studies, co-authored with Dr. Daniel Feenberg, they estimated that the TI during the 1993 Federal income tax increase was 0.75. This means that for every one percent reduction in after-tax income, taxable income decreased by 0.75 percent.

In dollar terms, suppose a taxpayer with $100,000 in after-tax income experiences a statutory tax increase of $1,000 to $99,000. In response, the taxpayer reduces his taxable income—perhaps by buying tax-free municipal bonds—by $750. As a result, government collects lower tax revenues (the $750 is tax-free) and the economy suffers significant deadweight losses (he could have went on vacation instead).

According to static federal revenue projections, the 1993 tax increase (both marginal income tax rates and the payroll tax) was estimated to raise $19.3 billion in additional revenue. However, based on behavior response, the actual additional revenue raised was estimated at a much lower level of $8.4 billion—a decline of 57 percent.

In addition, the deadweight loss was estimated at 15.9 billion, or nearly twice the behavior adjusted revenue of $8.4 billion.  Thus, federal taxpayers incurred a cost of nearly three dollars due to this tax increase—the dollar transferred to the federal government plus the deadweight loss of nearly two dollars.

More recently, new evidence has come to light that strongly supports the TI estimate used in their study. The study by Dr. Adam Looney and Dr. Monica Singhal, published by the John F. Kennedy School of Government at Harvard University, used two different data-sets that both reached virtually identical TI estimates of 0.75.