Case Study The Deadweight Loss Debate

Supply, demand, elasticity, deadweight loss—all this economic theory is enough to make your head spin. But believe it or not, these ideas go to the heart of a profound political question: How big should the government be? The reason the debate hinges on these concepts is that the larger the deadweight loss of taxation, the larger the cost of any government program. If taxation entails very large deadweight losses, then these losses are a strong argument for a leaner government that does less and taxes less. By contrast, if taxes impose only small deadweight losses, then government programs are less costly than they otherwise might be.

So how big are the deadweight losses of taxation? This is a question about which economists disagree. To see the nature of this disagreement, consider the most important tax in the U.S. economy—the tax on labor. The Social Security tax, the Medicare tax, and, to a large extent, the federal income tax are labor taxes. Many state governments also tax labor earnings. A labor tax places a wedge between the wage that firms pay and the wage that workers receive. If we add all forms of labor taxes together, the marginal tax rate on labor income—the tax on the last dollar of earnings—is almost 50 percent for many workers.

Although the size of the labor tax is easy to determine, the deadweight loss of this tax is less straightforward. Economists disagree about whether this 50 percent labor tax has a small or a large deadweight loss. This disagreement arises because they hold different views about the elasticity of labor supply.

Economists who argue that labor taxes are not very distorting believe that labor supply is fairly inelastic. Most people, they claim, would work full-time regardless of the wage. If so, the labor supply curve is almost vertical, and a tax on labor has a small deadweight loss.

Economists who argue that labor taxes are highly distorting believe that labor supply is more elastic. They admit that some groups of workers may supply their labor inelastically but claim that many other groups respond more to incentives. Here are some examples:

♦ Many workers can adjust the number of hours they work—for instance, by working overtime. The higher the wage, the more hours they choose to work.

"Let me tell you what I think about the elasticity of labor supply."

♦ Some families have second earners—often married women with children— with some discretion over whether to do unpaid work at home or paid work in the marketplace. When deciding whether to take a job, these second earners compare the benefits of being at home (including savings on the cost of child care) with the wages they could earn.

♦ Many of the elderly can choose when to retire, and their decisions are partly based on the wage. Once they are retired, the wage determines their incentive to work part-time.

♦ Some people consider engaging in illegal economic activity, such as the drug trade, or working at jobs that pay "under the table" to evade taxes. Economists call this the underground economy. In deciding whether to work in the underground economy or at a legitimate job, these potential criminals compare what they can earn by breaking the law with the wage they can earn legally.

In each of these cases, the quantity of labor supplied responds to the wage (the price of labor). Thus, the decisions of these workers are distorted when their labor earnings are taxed. Labor taxes encourage workers to work fewer hours, second earners to stay at home, the elderly to retire early, and the unscrupulous to enter the underground economy.

These two views of labor taxation persist to this day. Indeed, whenever you see two political candidates debating whether the government should provide more services or reduce the tax burden, keep in mind that part of the disagreement may rest on different views about the elasticity of labor supply and the deadweight loss of taxation.

I QUICK QUIZ: The demand for beer is more elastic than the demand for milk. Would a tax on beer or a tax on milk have larger deadweight loss? Why?

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