8.1 The Deadweight Loss of Taxation

8.1 a. How a Tax Affects Market Participants

The deadweight loss of taxation refers to the harm caused to economic efficiency and production by a tax. ^[1]

Example: Imagine the U.S. federal government imposes a 40% income tax on all citizens. Through this exercise, the government collects an additional $1.2 trillion in taxes. However, those funds are no longer available to be spent in private markets. Suppose consumer spending and investments decline at least $1.2 trillion, and total output declines $2 trillion. In this case, the deadweight loss is $800 billion. ^[1]

^{Deadweight Loss [2]}

8.1 b. Deadweight Losses and the Gains from Trade

Taxes result in a higher cost of production or higher purchase price in the market. This, in turn, creates a smaller production volume than would otherwise exist. Taxation reduces the returns from investments, wages, rents, entrepreneurship and inheritance. This reduces the incentive to invest, work, deploy property, take risks and save. ^[1]

Example: If the price of a glass of wine is $3.00 and the price of a glass of beer is $3.00, a consumer might prefer to drink wine. If the government decides to levy a wine tax of $3.00 per glass, the consumer might prefer to drink beer. ^[3]

^{Deadweight Loss [2]}