You have seen in previous posts that when households and firms make decisions in the presence of a tax that differ from those they would make in its absence, the burden of the tax can be shifted from those for whom it was originally intended. Now we can take the same logic one step further:
The amount by which the burden of the tax exceeds the revenue collected by the government is called the excess burden of the tax. The total burden of a tax is the sum of the revenue collected from the tax and the excess burden created by the tax. Because excess burdens are a form of waste, or lost value, tax policy should be written to minimize them. (Excess burdens are also called deadweight losses.)
The size of the excess burden imposed by a tax depends on the extent to which economic decisions are distorted. The general principle that emerges from the analysis of excess burdens is the principle of neutrality. Ceteris paribus, or all else equal, a tax that is neutral with respect to economic decisions is preferred to one that distorts economic decisions.
In practice, all taxes change behavior and distort economic choices. A product-specific excise tax raises the price of the tax item, and people can avoid the tax by buying substitutes. An income tax distorts the choice between present and future consumption and between work and leisure. The corporate tax influences investment and production decisions---investment is diverted away from the corporate sector, and firms may be induced to substitute labor for capital.
How Do Excess Burdens Arise?
The idea that a tax can impose an extra cost, or excess burden, by distorting choices can be illustrated by example. Consider a perfectly competitive industry that produces an output, X, using the technology shown in Figure 5. Using technology A, firms can produce one unit of output with seven units of capital (K) and three units of labor (L). Using technology B, the production of one unit of output requires four units of capital and seven units of labor. A is this the more capital-intensive technology.
If we assume labor and capital each cost $2 per unit, it costs $20 to produce each unit of output with technology A and $22 with technology B. Firms will choose technology A. Because we assume perfect competition, output price will be driven to cost of production, and the price of output will in the long run be driven to $20 per unit.
Now let us narrow our focus to the distortion of technology choice that is brought about by the imposition of a tax. Assume demand for the good in question is perfectly inelastic at 1000 units of output. That is, regardless of price, households will buy 1000 units of product. A price of $20 per unit means consumers pay a total of $20,000 for 1,000 units of X.
If demand is inelastic, buyers continue to buy 1000 units of X regardless of its price. (We shall ignore any distortions of consumer choices that might result from the imposition of the tax.) Recall that the tax is 50 percent, or $1 per unit of capital used. Because it takes 4 units of capital to produce each unit of output, firms which are now using technology B will pay a total tax to the government of $4 per unit of output produced. With 1,000 units of output produced and sold, total tax collections amount to $4,000.
The same principle holds for taxes that distort consumption decisions. Suppose that I prefer to consume bundle X to bundle Y when there is no tax but choose bundle Y when there is a tax in place. Not only do I pay the tax, I also end up with a bundle of goods that is worth less than the bundle I would have chosen had the tax not been levied. Again, we have the burden of an extra cost.
The larger the distortion that a tax causes in behavior, the larger the excess burden of the tax. Taxes levied on broad bases tend to distort choices less and impose smaller excess burdens than taxes on more sharply defined bases.
The more partial the tax, the easier it is to avoid. Broader bases and lower rates reduce the distorting effects of the tax system and minimize excess burdens.
The only tax that has no excess burden is the lump sum tax, where the tax you pay does not depend on your behavior or your income or your wealth. Everyone pays the same amount; there is no way to avoid the tax. In 1990, the government of prime minister Margaret Thatcher of Great Britain replaced the local property tax with a tax that was very similar to a lump sum tax. Such a tax is highly regressive (where the average tax burden decreases with income), and the perceived unfairness of it led her successor, John Major, to call for its repeal in 1991.
The Principal of the Second Best
Now that we have established the connection between taxes that distort decisions and excess burdens, we can add more complexity to our earlier discussions. Although it may seem that distorting taxes always creates excess burdens, this is not necessarily the case. A distorting tax is sometimes desirable when other distortions already exist in the economy. This is called the principle of second best.
At least two kinds of circumstances favor nonneutral (that is, distorting) taxes: the presence of externalities and the presence of other distorting taxes
If some activity by a firm or household imposes costs on society that are not considered by decision-makers, then firms and households are likely to make economically inefficient choices. Pollution is the classic example of an externality, but there are thousands of others. An efficient allocation of resources can be restored if a tax is imposed on the externality-generating activity that is exactly equal to the value of the damages caused by it. Such a tax forces the decision maker to consider the full economic cost of the decision.
Because taxing for externalities changes decisions that would otherwise be made, it does in a sense "distort" economic decisions. But its purpose is to force decision makers to consider real costs that they would otherwise ignore. In the case of pollution, for example, the distortion caused by a tax is desirable. Instead of causing an excess burden, it results in an efficiency gain.
A distorting tax can also improve economic welfare when there are other taxes present that already distort decisions. Suppose there were only three goods, X, Y, and Z, and a 5 percent excise tax on Y and Z. The taxes on Y and Z distort consumer decisions away from those goods and toward X. Imposing a similar tax on X reduces the distortion of the existing system of taxes. When consumers face equal taxes on all goods, they cannot avoid the tax by changing what they buy. The distortion caused by imposing a tax on X corrects for a preexisting distortion---the taxes on Y and Z.
Let's return to the example described earlier in Figures 5 and 6. Imposing the tax of 50 percent on the use of capital generated revenues of $4,000 but imposed a burden of $6,000 on consumers. A distortion now exists. But what would happen if the government now imposed an additional tax of 50 percent, or $1 per unit, on labor? Such a tax would push our firm back toward the more efficient technology A. In fact, the labor tax will generate a total revenue of $6,000, but the burden it imposes on consumers would be only $4,000. (It is a good idea for you to work these figures out yourself.)
Optimal Taxation The idea that taxes work together to affect behavior has led tax theorists to search for optimal taxation systems. Knowing how people will respond to taxes would allow us to design a system that would minimize the overall excess burden. For example, if we know the elasticity of demand for all traded goods, we can devise an optimal system of excise taxes that are heaviest on those goods with relatively inelastic demand and lighter on those goods with relatively elastic demands.
Of course, it is impossible to collect all the information required to implement the optimal tax systems that have been suggested. This point brings us full circle, and we end up where we started, with the principle of neutrality: All else equal, taxes that are neutral with respect to economic decisions are generally preferable to taxes that distort economic decisions. Taxes that are not neutral impose excess burdens.
*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 366-369*
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