merged

To minimize the deadweight loss, a tax should;
a. Be broad-based. A broad-based tax has little effect on relative prices, and thus has little
effect on the decisions made in the private market.
Example 11: If a 1% sales tax is imposed on all consumer goods and services, consumption will
fall. But since the relative prices of all goods and services will be unchanged, the mix of goods
and services consumed will be unchanged. The market equilibrium, after the tax, will still reflect
private decisions about costs and benefits.
If a narrowly-based tax is imposed (e.g. a 50% sales tax on dairy products), the decisions in the
private market will be distorted (people buy fewer dairy products, not based on costs and
benefits, but based on the tax). For an extreme example; a 5000% tax is imposed on ice cream.
At this tax rate, no ice cream is produced or consumed. Many mutually beneficial transactions are
eliminated. And the government collects zero tax revenue from the tax. The only effect of the tax
is to impose excess burden.
b. Have low rates. Low tax rates help to minimize the effect on the decisions made in the
private market.
Example 12A: A tax rate of 1% on income would have little effect on the production decisions of
households. Probably no one will withdraw from the labor market due to the disincentive caused
by a 1% income tax. A tax rate of 50% on income would have a larger effect on the production
decisions of households. Many persons may withdraw from the labor market due to the
disincentive caused by a 50% income tax or may be less motivated to improve the productivity of
their labor. What if a 100% tax is imposed on income? At this rate, no income will be produced.
The economy loses out on trillions of dollars worth of production. And the government collects
zero tax revenue from the tax. The only effect of the tax is to impose excess burden.
Example 12B: We will see in Chapter 17 that one of the factors that determines the size of the
deadweight loss of a tax is the tax rate. A lower tax rate will mean a smaller deadweight loss. A
higher tax rate will mean a larger deadweight loss. Refer to Examples 15 and 17 in Chapter 17 to
see how an increase in the tax rate increases the deadweight loss of a tax.
c. Be imposed on inelastic goods. The price elasticity of demand and supply for a good
determines how responsive buyers and sellers are to a change in the price of the good. For
inelastic goods, buyers and sellers are not very responsive to a change in price. Thus a tax
imposed on an inelastic good will have a relatively small effect on the market outcome.
Example 13: We will see in Chapter 17 that one of the factors that determines the size of the
deadweight loss of a tax is the price elasticity of demand and supply. The more elastic the
demand curve, the greater the deadweight loss of the tax. The less elastic the demand curve, the
smaller the deadweight loss of the tax. Likewise, the more elastic the supply curve, the greater
the deadweight loss of the tax. And the less elastic the supply curve, the smaller the deadweight
loss of the tax. Refer to Examples 15 and 16 in Chapter 17 to see how an increase in the price
elasticity of demand for a good increases the deadweight loss of a tax imposed on the good.
Is the Federal Personal Income Tax a Good Tax?
The largest source of tax revenue for the federal government is the federal personal income tax.
Having just considered the characteristics of a good tax, we can evaluate whether the personal
income tax is a good (economically efficient) tax. Unfortunately, it is not. The federal personal
income tax imposes a large excess burden. The personal income tax is extremely complicated.
The federal income tax code contains about 3.8 million words. (That’s almost 5 times as many
words as are in the Bible.) This complexity causes the collection cost of the tax to be high. In
2014, the IRS had about 84,000 full-time employees and a budget of over $11 billion.
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Taxes, Deficits, and the National Debt 13 - 6