Tax inefficiencies and their implications for optimal taxation. Taxation and economic efficiency graphical approach. Elasticities determine tax inefficiency.

Just as the price elasticities of supply and demand determine the distribution of the tax burden among market participants, they also determine the inefficiency of taxation: as demand and supply elasticities rise, the deadweight loss of taxation grows. This lesson is illustrated in Figure 20-2 for a tax on producers in two different markets. In panel (a), demand is relatively inelastic. A tax on producers shifts the supply curve upward from S1 to S2. This leads to a large rise in market prices from P1 to P2 and a relatively small reduction in market quantity from Q1 to Q2. Deadweight loss is determined by the reduction in socially efficient trades, so the deadweight loss in this case (area BAC) is small. If the government were to tax insulin, for example, there would be very little effect on the quantity of insulin demanded, and therefore little deadweight loss. In panel (b), demand is more elastic. Thus, when the tax on suppliers shifts the supply curve from S1 to S2, there is a small rise in market prices from P1 to P2, but a relatively large reduction in market quantity from Q1 to Q2. As a result, the deadweight loss triangle (BAC) is much larger because many socially efficient trades (where the pre-tax demand is above the pre-tax supply) are not being made. Suppose, for example, that the government levied a tax on a particular fast-food restaurant, McGruber’s. This tax would cause a largereduction in demand for McGruber’s meals because individuals would shift their consumption to close substitutes (like Gruber King). This change is inefficient, however, because the fact that individuals were eating at McGruber’s before the tax indicates that McGruber’s meals are their preferred choice. The large deadweight loss occurs because many individuals move away from their preferred choice in response to the tax.

the inefficiency of any tax is determined by the extent to which consumers and producers change their behavior to avoid the tax; deadweight loss is caused by individuals and firms making inefficient consumption and production choices to avoid taxation

The efficiency cost of taxation is measured by the deadweight loss arising from reduced consumption of a good.

This efficiency cost rises with the elasticities of supply and demand and with the square of the tax rate.

The latter point implies that taxes have larger efficiency costs in the presence of preexisting distortions, such as externalities, subsidies, and existing taxes, and that progressive taxes have a larger efficiency cost than proportional taxes.

Optimal commodity taxation involves trading off the desire to tax inelastically demanded goods at a higher rate against the desire to tax the broadest set of commodities and minimize overall tax rates, leading under some assumptions to the “inverse elasticity” rule of taxing goods in inverse proportion to their elasticity of demand.

Optimal income taxation involves trading off the desire for equity against the distortion costs associated with taxing higher-income groups at a higher rate. Simulations suggest that, as a result, the optimal income tax system has flat or falling marginal tax rates but rapidly rising average tax rates.

Accounting for tax-benefit linkages can reduce the measured deadweight loss of payroll taxation and increase the expected burden of payroll taxes on workers. Since such linkages are prominent in social insurance programs, both theory and evidence suggest that the burdens of those taxes are fully borne in the form of lower worker wages.

1-d; 2-a; 3-e; 4-a; 5-d; 6-e; 7-e; 8-d; 9-c; 10-a.