Determinants of deadweight loss

 

First, deadweight loss rises with the elasticities of demand and supply: the more opportunities market participants have to consume or produce substitutes (the more elastic is demand or supply), the greater the inefficiency they will create by substituting. Second, the deadweight loss rises with the square of the tax rate (t2), so that the distortion from any given amount of tax is greater as the existing tax rate increases.

 

Deadweight loss and the design of efficient tax systems

The insight that the marginal deadweight loss of a tax rises with the tax rate has a number of important implications for the design of efficient tax policy.

 

A Tax System’s Efficiency Is Affected by a Market’s Preexisting Distortions

(Preexisting distortions: market failures, such as externalities or imperfect competition, that are in place before any government intervention). The fact that the marginal deadweight loss rises with the tax rate means that preexisting distortions in a market, such as externalities, imperfect competition, or existing taxes, are key determinants of the efficiency of a new tax.

 

Progressive Tax Systems Can Be Less Efficient

Another implication of these rules about deadweight loss is that there can be large efficiency costs to moving from a proportional (equal average tax rates on all) to a progressive (higher average tax rates on the rich) tax system. Moving to a progressive system means narrowing the base for taxation—that part of the tax that applies to the rich is levied on only the narrow income base of the rich. Assume for now that the poor and the rich have the same elasticity of income generation with respect to the tax rate, so that a percentage rise in the tax rate lowers taxable income by the same percentage amount for both groups. Under this assumption, it is more efficient to tax all individuals at an equal rate than to exclude some individuals from taxation and tax other individuals at a higher tax rate to make up for the lost revenues. The efficiency lost by taxing a subset of individuals more highly is larger than the efficiency gained by excluding some individuals from taxation.

Tests

 

1. a

2. c

3. b

4. e

5. a

6. a

7. e

8. b

9. b

10. c

 

3.1. Suppose the federal government is considering raising the minimum wage to $10 per hour. An economist testifies to Congress that this plan is inefficient and causes deadweight loss.

a) Show graphically the deadweight loss caused by the minimum wage law.

b) Suppose that you are a member of Congress and you believe in the utilitarian social welfare function. How would you determine whether to vote for or against the policy?

With a utilitarian social welfare function, society’s goal is to maximize the sum of individual utilities:

SWF = U1 + U2 +... + UN

The utilities of all individuals are given equal weight, and summed to get total social welfare. This formulation implies that we should transfer from person 1 to person 2 as long as the utility gain to person 1 is greater than the utility loss to person 2. In other words, this implies that society is indifferent between one util (a unit of well-being) for a poor person and one for a rich person.

c) Explain why this policy choice demonstrates a trade-off between equity and efficiency.

Under certain assumptions, efficiency and equity are two separate issues. In these circumstances, society doesn’t have just one socially efficient point, but a whole series of socially efficient points from which it can choose. Society can achieve those different points simply by shifting available resources among individuals and letting them trade freely. Indeed, this is the Second Fundamental Theorem of Welfare Economics: society can attain any efficient outcome by a suitable redistribution of resources and free trade.

In practice, however, society doesn’t typically have this nice choice as society most often faces an equity–efficiency trade-off, the choice between having a bigger economic pie and having a more fairly distributed pie. Resolving this trade-off is harder than determining efficiency-enhancing government interventions. It raises the tricky issue of making interpersonal comparisons, or deciding who should have more and who should have less in society.

d) Explain the Earned Income Tax Credit. Explain why the EITC may provide equity with small losses in efficiency.

3.2. In a recent study, Americans stated that they were willing to pay $70 billion to protect all endangered species and also stated that they were willing to pay $15 billion to protect a single species. Which problem with Lindahl pricing is demonstrated? Explain.

 

This illustrates the preference knowledge problem. Lindahl pricing requires an accurate

measure of each individuals marginal willingness to pay, but people often do not have

a good idea of their own marginal willingness to pay for things that are not ordinarily

bought or sold in the market. Endangered species protection is an abstract concept, so

it is unlikely that people had thought about their willingness to pay for it before being

surveyed. At $15 billion per species, all endangered species could not be protected for

$70 billion. It appears that the respondents either overstated their willingness to pay to

preserve one species or understated their willingness to pay to preserve all endangered

species.

VARIANT 6