What is Deadweight Loss of Taxation?

Have you ever thought what could Government’s major source of Income come be from? Yes, the correct answer to the question is Tax.  An Imposition of Compulsory levies or a mandatory fee by government on an individual or an organization in called Tax. But have you ever heard about the concept Deadweight Loss of Taxation

So here we will discuss about Meaning of Deadweight Loss of Taxation, Its Importance

What is Deadweight Loss?

Deadweight Loss is basically a cost to the society caused when the supply and demand are not in equilibrium created mainly because of market inefficiency. The concepts such as rent controls, price controls, minimum wages and taxation can cause deadweight loss. If the prices of the product is not accurately reflected it changes the consumer behavior and perspectives which creates a negative impact on the economy.

What is Deadweight Loss of Taxation?

When there is economic inefficiency due to imposition of various taxes by Government, and when equilibrium cannot be achieved due to market inefficiency, it is called Deadweight Loss due to Taxation.

Understanding the Deadweight Loss of Taxation Briefly

The first situation of Deadweight Loss is Monopoly. The Monopolist produces such quantity where marginal revenue equals marginal cost. The price is determined by the demand curve at this quantity. The price is determined by the demand curve at this quantity. A monopoly makes a profit equal to total revenue minus total cost. When the total output is less than optimal, then deadweight loss occurs.

The another situation where deadweight Loss occurs is due to price restrictions. It also arises when taxation or subsidies are imposed. Tax incidence is the way in which the burden of tax falls on the seller and the buyer and they are the ones who suffer deadweight loss. It depends on elasticity of demand and supply. A tax creates difference in the price paid by the buyer and the price received by the seller. The tax liability borne by the buyer is the difference between the price paid under the tax and the price paid in the competitive equilibrium. The liability borne by the buyer is higher when all else being the same and if demand is less elastic. The burden borne by the seller is higher if all else being the same and if supply is less elastic.

The deadweight loss from the tax measures the sum of the buyer’s lost surplus and the seller’s lost surplus in the equilibrium with the taxation. The total amount of the deadweight loss therefore also depends on the elasticities of their supply and demand. The smaller these elasticities will be, the closer the equilibrium quantity traded with a tax will be to the equilibrium quantity traded without a tax, and the smaller will be the deadweight loss.

How Deadweight Loss is created?

Laws such as minimum wage can create deadweight loss by causing employers to pay more to the employees. Price ceilings such as rent controls can create a deadweight Loss. Consumers in such a situation experience the shortage and producers also earn less.

Taxes also create deadweight Loss because it prevents people from engaging in purchasing because the final price of the product is above the market price equilibrium. If the taxes on the item rise the burden is often split between the producer and the consumer which leads to producer getting lesser profit and the consumer paying higher price for the products. This results in lower consumption which overall reduces the benefits the consumer market would have received otherwise.

Deadweight Loss Formula =  0.5 * (P2 – P1) * (Q1 – Q2)

Where,

• P1 – Original price of goods/service
• P2 – New Price of goods/service
• Q1 – Original Quantity
• Q2 – New Quantity

Let us understand the Deadweight Loss of Taxation through an Example

There is a new Cake Shop which is opened in your neighborhood-od which sells one cake for ₹ 350 each. Now you presume that the cake actual price is ₹370 and is ready to pay for it. Now assume Government imposes tax on food items which raises the cost of cake to ₹ 400.  Now at ₹ 400 you feel that the cake is overpriced and the cost is not fair and you decide not to buy the cake.

So here many consumers might rethink about buying such an overpriced cake. This is due to the taxation imposed by the Government which has created a loss for the shop owner. If due to this there is a continuous decline in demand for cakes, the cake owner might have to wind up his business.

Let us take one more example for calculation of Deadweight loss due to Taxation

Let us consider that Mr. Aman wants to take his wife for watching a movie. The price for the ticket is ₹ 150. 600 tickets are sold throughout the day. However the Government increased entertainment tax to 30%. Now the tickets have become costly and many tickets are unsold so, here there is a deadweight loss due to taxation.

So Deadweight Loss =

So here Deadweight Loss caused due to taxation is 1125.

Conclusion

A major practical difficulty in measuring the excess burden of a single tax is that excess burden is a function of demand interactions that are very difficult to measure.

For example, a tax on labor income is expected to affect hours worked, but may also effect the intensity with which people work, retirement, and the extent to which compensation takes tax-favored in place of tax-disfavored form. In order to estimate the excess burden of a labor income tax, it is in very much necessary to estimate the effect of the tax on these and other decision margins. Similar difficulties happen while measuring other taxes. In practical it is very hard to get reliable estimates of the impact of the taxation on just one variable.