Deadweight Losses

If the government taxes ice cream people eat less ice cream and more frozen yogurt. If the government taxes housing people live in smaller houses and spend more of their income on other things. If the government taxes labor earnings people work less and enjoy more leisure.

Because taxes distort incentives they entail deadweight losses. As we first discussed in the deadweight loss of a tax is the reduction in economic well-being of taxpayers in excess of the amount of revenue raised by the government. The deadweight loss is the inefficiency that a tax creates as people allocate resources according to the tax incentive rather the true costs and benefits of the goods and service that they buy and sell.

To recall how taxes cause deadweight losses consider an example. Suppose that Joe places an S8 value on a pizza and Jane places a S6 value on it. If there is no tax on pizza the price of pizza will reflect the cost of making it. Let’s suppose that the price of pizza is $5 so both Joe and Jane choose to buy one. Both consumers get some surplus of value over the amount paid. Joe gets consumers surplus of $3 and Jane gets.

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