Freeman

ARTICLE

The Hidden Cost of Taxation

The Costs of Funding Government Spending Are Largely Unseen

MARCH 01, 2000 by DWIGHT R. LEE

In my last column I pointed to the harm government typically does when it attempts to promote prosperity by creating jobs. Such attempts always distort the market cooperation that directs people into those jobs in which they create the greatest value. But government does have legitimate, though limited, functions, and performing them requires hiring people. If government confines itself to its legitimate role and performs efficiently, government employees will produce more value than they can in alternative jobs. Unfortunately, government neither limits itself to its legitimate functions, nor performs efficiently. I shall consider one reason for this government failure, a reason based on a distortion in the political process. Because the costs of taxation are never fully considered in political decisions, those decisions are biased in favor of excessive taxing and spending.

The costs of taxation are dispersed widely. Everyone pays taxes, so when a general tax is increased it is spread over so many people that no one individual will find the increase very burdensome. Conversely, if the tax is decreased, no one may perceive a significant benefit. And even if some people do notice the costs of a tax increase, or the benefits of a decrease, an effort to organize other taxpayers (given their large numbers, geographic dispersion, and diverse interests) to take effective political action would be difficult. This helps explain why the costs of taxation are largely ignored politically. Politicians can nudge certain taxes up without hearing from taxpayers, except for some brief grumbling.

Of course, not everyone is politically passive about tax burdens. Relatively small groups with an intense interest in the burden of particular taxes are well positioned to influence policy on those taxes. The federal tax code is full of highly specific loopholes for particular industries, and often for particular companies. Also, some general tax breaks, like interest deductions on mortgages, are seen as promoting a desirable objective (home ownership), are easily noticed as significant by taxpayers, and also benefit an organized interest (homebuilders). Thus they are politically popular.

But the tax loopholes permeating almost all tax systems add to insidious “dead weight” costs of taxation, which result from distorted economic decisions caused by all taxes, but aggravated by tax loopholes. These costs are insidious because besides being widely dispersed, they go undetected even by those who suffer from them. The result is an even greater bias toward excessive taxing and spending.

The Tax Wedge

All taxes drive a wedge between what buyers pay and sellers receive. Consumers pay more than producers receive because of sales taxes, and employers pay more than employees receive because of income taxes. Thus some production and effort worth more than it costs is not provided, and the value sacrificed is the dead-weight cost of taxation. This deadweight cost is greater when the tax system contains loopholes. When some products or activities are taxed more heavily than others, people will favor those taxed less even when they are less valuable than those more heavily taxed. For example, when much of the cost of a house is deducted from taxable income but not the cost of clothing, people will sacrifice clothing to buy a larger house, even though they value the clothing more than the additional housing space. When the profits in one industry are taxed less than the profits in other industries, people will continue adding to investments in the low-tax industry even though the additional investment would create more value in other industries.

Dead-weight costs of taxation go unnoticed, even by those who pay them, because instead of taking from people what they already have, they take from people what they would have had, but never get. No one sees the extra value that would have been created by economic decisions that would have been made without taxes. The problem here is similar to the one that governments create, and take advantage of, with tax withholding. When taxes are deducted directly from our paychecks, few of us pay much attention to just how much we are paying. Indeed, people often get excited when they overpay their taxes through withholding and get a refund at the end of the year. The tax withdrawals were hardly noticed (and neither is the interest lost because the government had the money), but the refund is obvious and seems to be a gift from the government.

Even though unnoticed, the dead-weight costs of taxation are real and significant. It has been estimated that the dead-weight costs of the federal government’s raising an additional dollar equal 39 cents.1 So for the federal government to obtain an additional dollar, taxpayers have to sacrifice $1.39—$1.00 taken from them directly, plus another 39 cents in value they could have had but never will. But because people are unaware of these dead-weight costs, the political process ignores them, and government decisions that appear efficient actually destroy wealth.

Consider a government program to create jobs that pay $10 million a year in salaries. Assume that the government workers who receive these salaries will create a service worth $12 million a year. This program will be heralded as an economic success, yielding $2 million above its costs (I assume that the only input into the program is labor). But the program is a loser, as is obvious once the dead-weight costs of taxation are recognized. Based on the above dead-weight costs estimate, it will cost approximately $13.9 million dollars to raise $10 million in tax revenue-$10 million in direct tax payments, plus another $3.9 million in value sacrificed because of the economic distortions caused by those tax payments. So instead of being an economic success, the program destroys $1.9 million dollars’ worth of value a year.

The Seen and Unseen

All public policies have both seen and unseen effects. Frederic Bastiat, the nineteenth-century French economist, pointed to many of the economic errors people make by focusing on the seen and ignoring the unseen.2 Although Bastiat did not discuss the unseen dead-weight costs of taxation (he did point out that politicians tend to ignore even the direct costs of taxation), there are few better examples of his general point than taxing and spending. The benefits of government spending are easily seen, and often concentrated on organized-interest groups that exaggerate them to politicians. But the costs of funding the spending, especially the dead-weight costs, are largely unseen. The result is that the political process overemphasizes the benefits of spending, under-emphasizes the costs, and consistently expands spending to economically destructive levels.


Notes

  1. See Dale Jorgenson and Kun-Young Yun, “The Excess Burden of Taxation in the United States,” Journal of Accounting, Auditing and Finance, Fall 1991, pp. 487-508.
  2. Frederic Bastiat, “What Is Seen and What Is Not Seen,” in Selected Essays on Political Economy (Irvington-on-Hudson, N.Y.: Foundation for Economic Education, 1995 [1968]).

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March 2000

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DWIGHT R. LEE

Dwight R. Lee is the O’Neil Professor of Global Markets and Freedom in the Cox School of Business at Southern Methodist University.

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