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The Deadweight Costs of Taxation

Please find attached an article that appeared in the Otago Daily Times today, 8 September 2006.

The Deadweight Costs of Taxation

The 2001 McLeod Tax Review pointed out that taxes can never be raised costlessly. It noted that apart from compliance and administrative costs, taxes impose ‘economic costs’ because they induce individuals to make decisions that they would not have made in their absence. These costs (referred to as ‘excess burden’ or ‘deadweight costs’) can be regarded as the difference between the amount individuals would be willing to pay to avoid having a tax imposed and the net amount of tax collected, after allowing for costs of compliance and administration.

Deadweight costs can be illustrated in the following way.

Suppose Jane cleans Mary’s house each week. To make the job worthwhile Jane wants at least $80. Mary would be prepared to pay up to $120 for a clean house. They agree to a rate of $100, with each gaining $20 from the deal – a total economic surplus of $40.

Now suppose the government slaps a tax of $50 on cleaning services. There is now no price that Mary can pay Jane to make the deal work. The most it would be worth her while to offer would be $120, but that would leave Jane with only $70 in the hand, which she is not prepared to accept. Conversely, for Jane to get $80 Mary would have to pay her $130, which is more than the value she puts on a clean house.

So the arrangement falls through – Jane goes without the income and Mary lives in a dirtier house. The tax has made them worse off by a total of $40 – the previous surplus – and the government gets no tax revenue.

These effects of taxes on behaviour are pervasive. Typically if you tax something you get less of it. Thus taxes on alcohol and tobacco are aimed a reducing drinking and smoking.

The same goes for income tax. Finance minister Michael Cullen has said that if he had to pay less tax he would not work more. However, income taxes affect many things other than the number of hours worked, such as whether to train or take a promotion, whether a second member of a household takes a job, the timing of retirement, and decisions on whether to consume, save and invest. More income tax means less national income.

Whether deadweight losses are small or large depends on many factors, particularly the size of the tax. Higher rates of tax generate larger losses, and they increase exponentially as taxes rise. This is one of the arguments for a broad-base, low-rate tax system. A 10% tax rate might generate a marginal excess burden of 5 cents (deadweight loss of 5 cents per dollar of revenue raised), which rises to 20 cents when the tax rate is 20% and to $1.25 when the tax rate is 50% (around the effective rate for many Working for Families recipients).

The deadweight cost of taxation has risen in New Zealand with increases in the size of government. A study by Erwin Diewert and Denis Lawrence published by the Business Roundtable in 1994 found that the excess burden arising from labour taxation (primarily taxation on the income of wage earners and the self-employed) had gone up from 5 cents to 18 cents per additional dollar of revenue raised between 1972 and 1992. The marginal excess burden of consumption taxation (mainly GST) increased from about 5 cents to 14 cents.

What this means is that, for it to be justified, a government project financed by increased labour taxation would need to return $1.18 net of collection costs for each dollar spent on it. If it returned only $1, roughly speaking 18 cents of national income would be sacrificed. Put another way, there would be an 18 cent gain to the economy and a $1.18 gain to the private sector (households and firms) from cutting government spending by $1.

These figures are likely to be conservative as the top income tax rate has risen since 1992 and the deadweight cost of taxation of capital income is likely to be higher than for labour and consumption taxation – perhaps as high as 50%. Treasury guidelines provide for a figure of 20% to be applied to the costs of public sector projects funded from taxation to reflect the deadweight loss.

The key insight from all this is that the cost of an additional $1 in taxes and spending is much more than $1. It is likely that many government spending programmes do not yield benefits of $1.18 for each dollar spent. Thus taxes need to be treated like the scarce resource that they are and not used to fund wasteful programmes or services that many people could fund themselves, given lower taxes and higher per capita incomes. Excessive taxation hurts economic growth and people’s welfare in general.

Roger Kerr is the executive director of the New Zealand Business Roundtable.


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