When I first enrolled in graduate school, I was pretty high on taxes.
Maybe it was the “contrarian” in me. Maybe it was the excitement of Bernie Sanders suddenly making “socialism” a mainstream word in the political lexicon. Or maybe it was just the fact that I was going to policy school and I knew programs were funded by taxes so I liked them. Suffice it to say, I was quick to dismiss anything nasty people had to say about taxes as political posturing.
This made it hard for me to accept the assurances from my economics professors that taxes did indeed destroy social value.
This does not mean that government necessarily destroys social value, but many taxes do destroy social value in one place, even if it creates it in another place.
The main way taxes do this is through distorting markets. By tagging an extra price on transactions, consumers and producers self-select out of markets they would otherwise be competitive in. This increases prices and reduces quantities traded at the same time.
Not all taxes are created equal, though. Some taxes are incredibly distortionary. Some barely distort markets at all. Some are negatively distortionary–they actually make markets work better.
How do we know which taxes are more distortionary and which are less? We mainly find this through empirical study. That being said, there is a general hierarchy of taxes that can help you have a reasonable idea of which are most or least distortionary.
Most distortionary: Narrow-based taxes on elastic goods
The taxes that distort the economy most are narrow taxes on single goods. These end up being distortionary because they shift spending decisions so wildly. To understand the intuition behind this, imagine a tax on hamburger buns. This would lead to a reduction in purchases of hamburger buns because they are more expensive, but would also lead to less consumption of hamburger patties, more consumption of hotdog buns, and more consumption of hotdogs, the latter two of which serve as substitutes for hamburger buns and hamburgers.
Analyses of federal taxes in Australia lend support to this claim. House sale taxes have tax burdens that exceed their value of revenue raised. New car taxes destroy nearly a dollar in value for every dollar they raise in revenue. Since purchasers of new cars can substitute to purchasing used cars and buyers of property can instead become renters of property, these taxes end up shifting preferences from ideal purchases to secondary purchases and reshuffling markets.
Less distortionary: broad-based taxes
So if assessing taxes on narrow goods leads to distortion, shouldn’t we instead levy taxes on broad sets of goods? Well this has been the logic of economists for years now: levy taxes on a broad range of goods so they have less of an impact on the broader economy. The logic here is that if you tax something broad like labor, purchases, or property, which people cannot avoid, then their purchasing decisions will not change as much as if you tax something narrow.
The federal Office of Management and Budget estimates marginal excess tax burden at 25 cents of value destroyed for every dollar of revenue raised, much lower than the above estimates for the cost of narrow taxes. Researchers have put the cost of a broad-based sales tax at 13 cents on the dollar and a broad-based property tax at 14 cents on the dollar. Estimates on value added taxes, which spread a tax throughout the stages of production in an economy, should theoretically be even lower but land in the same territory as these estimates in the empirical evidence.
Not distortionary: user fees
Some taxes and fees like gas taxes are designed to mimic market mechanisms. While roads are public goods constructed and maintained with tax dollars, a major source of their funding is through gas taxes. Levying a gas tax and earmarking these funds for road maintenance means that people and companies who buy more gas (and presumably use roads more) pay more taxes. So the people who are paying for the roads are the people who are using the roads.
Ideally, a perfect user fee would have a social cost that equals its social benefit, netting a marginal excess tax burden of zero. This is not always the case, however. The rise of electric vehicles means that many people who use roads are not paying gas taxes, which makes gas taxes a less perfect user fee than they would be otherwise.
You can imagine other user fees that would have no distortion, like fees for water, sewage, and waste disposal conducted at the city level. If these are made in proportion to the volume of service, then these fees provide no distortion to the economy: their social benefits can theoretically equal their social costs.
Negatively distortionary: Pigouvian taxes
A final category of taxes are taxes that actually enhance market efficiency: Pigouvian taxes. Named after the father of welfare economics Arthur Pigou, this is a category of taxes that are deployed when a market has total social costs that exceed the private benefits realized from the transaction. Examples of these are carbon taxes and cigarette taxes. Since future generations impacted by climate change and breathers of secondhand smoke are not willing participants in markets in carbon and cigarettes respectively, the marginal social costs of these transactions exceed the marginal private costs, representing a failure in the current market. Taxes on carbon and cigarettes bring private costs in line with social costs, making the markets more efficient than they would be otherwise.
These are all just rules of thumb: there can be some narrow-based taxes that have low elasticities that are not very distortionary. There are also some user fees that do not operate efficiently and cause large distortions. And distortion is not the only policy-relevant dimension of tax policy. Often we are willing to trade off efficiency for equity outcomes, like we would do with a graduated income tax or a corporate tax. But I hope this framework at least gives you an idea of the logic behind marginal excess tax burden and a framework to approach tax policy and design.
