Apparent inequity in the tax system is a major concern, but economists focus their studies on inefficiency, an area permitting greater precision. In his Wealth of Nations, Adam Smith suggested that efficiency in taxation requires taxes to be certain (unavoidable) and convenient and that collection costs be minimized relative to the tax yield.
Government’s net tax revenues ideally would exactly equal costs incurred by taxpayers. Taxpayers’ costs unavoidably exceed net government revenues, however, because of (a) government’s administrative costs (e.g., operating expenses for the Internal Revenue Service) and (b) taxpayers’ compliance costs (e.g., time absorbed in keeping records for taxes and filling out tax reports, or payments to tax lawyers and accountants).
Total costs of a tax, however, include other, more subtle costs and ultimately equal the losses of disposable (after-tax) income and purchasing power to taxpayers. Consider an untaxed individual who enjoys a certain standard of living, including current levels of government services. Now impose a tax on that person.
The total burden of a tax equals the amount that would have to be paid the individual on whom the burden falls to make that person just as well off with the tax as without it.
Differences between total tax burdens and net government revenues reflect inefficiency.
If high state taxes on beer cause New Yorkers to drive to New Jersey to buy their brew, then the total tax burden includes not only the revenues actually collected by New York, but also the time and transportation costs to the New Yorkers who avoid the tax. If some of these commuters wind up dying in traffic accidents, or if they drunkenly kill other people, then this loss of life is also a part of the total burden of the tax. Excess burdens arise whenever people are made worse off than the losses imposed by the tax funds actually collected from them.
The excess burden of a tax is the difference between the total burden and the tax revenue collected by government.
In addition to administrative and compliance costs, taxes impose excess burdens if they distort the prices faced by consumers, workers, savers, investors, or business decision-makers.
Kyoto, Japan, imposed taxes on visitors to Buddhist temples in 1985. Most temple priests strongly opposed the tax as a violation of their religious principles and initially let visitors in free rather than pay the tax. But the priests eventually closed the temple doors to visitors, the city collected no revenue, and tourism declined (an excess burden). Finally, the city abolished the tax.
Supply and demand analysis can allow us to scrutinize excess burdens. In Figure 6, S0 and D0 reflect the nontaxed supply and demand for quarts of milk. For simplicity, we assume constant production costs at P0 per quart. Suppose a tax of t per quart were imposed on milk. This tax shifts the supply curve to S1 from the buyer’s perspective. As buyers and sellers adjust to this tax, consumers watch the price of a quart of milk rise from P0 to P1 while the amount sold falls from Q0 to Q1. At Q1 quarts monthly, the difference between the price paid by the buyer (P1) and the price received by the seller (P0) exactly equals tax t. Prior to the tax, consumers paid 0aef for Q0 quarts of milk, but would have willingly paid 0def. Thus, they enjoyed a consumer surplus of ade. The rise in the consumers’ price to P1 shrinks consumer surplus by the area below the consumer demand curve but above the original price (P0) and below the new price (P1). The consumer surplus lost equals the trapezoid abce.
Government, however, gains monthly revenues of t per bottle for Q1 quarts of milk, a total of area abch, which it can use to meet taxpayers’ wants. The total loss of consumer surplus minus the gains to government equals area hce (abce – abch). The triangle hce is a deadweight loss to society from this tax; it is an excess burden. These losses, however, may be more than offset by consumer surpluses from government services provided with the tax revenues. Of course, if government spending is inefficient, this graph of excess burden may understate consumers’ losses. Government ideally minimizes the excess burdens incurred in securing any given total of tax revenues.
The neutrality principle combines and extends Adam Smith’s certainty, convenience, and economy principles. Ideally, the costs of transferring purchasing power from private hands into the public purse are minimized.
A neutral tax distorts neither consumer buying patterns nor the production methods used by firms. Its total burden just equals the tax revenue collected, there are no excess burdens.
Tax neutrality requires that the tax directly cause only income effects, not substitution effects.1 That is, a neutral tax does not induce behavior to avoid the tax; behavior changes only because of lost purchasing power. This requires that taxes be unavoidable. Lump sum taxes, which are based solely on the existence of the taxed individual, are examples of neutral taxes.
No action by taxpayers (perhaps at the behest of their accountants or lawyers) should enable them to avoid payment, and the only impact on taxpayers should be declines in their purchasing power. For example, tax structures should not encourage fringe benefits in work contracts instead of direct wage payments or financial investment in tax-free municipal bonds rather than capital equipment. Nor should it encourage consumption of housing instead of groceries or clothes. (Our tax system has done all these things.) Taxes that directly alter the relative benefits and costs facing consumers or business decision-makers are nonneutral and inefficient. A neutral tax will be more certain, convenient, and economical than a nonneutral tax.
All taxes, unfortunately, induce substitution effects by directly altering relative prices, thereby changing the behavior of consumers and firms. As a result, taxes are often evaluated by their relative neutrality. Because all taxes are somewhat flawed, economists normally try to specify which are the most nearly neutral (those with the smallest excess burdens) and least inequitable in generating governmental revenues.