Deadweight loss. Not a term that is typically thrown around in libertarian circles, but is just as important of a concept. Deadweight loss occurs when something intervenes in the market and shifts the equilibrium price. Price ceilings, price floors, tariffs, and other externalities can create these pockets. However, I want to talk about deadweight loss in reference to taxation.
In a perfect market, meaning that there are no forms of intervention, there is equilibrium. Equilibrium (+) is the intersection of the highest price that a commodity can command at a specific amount that can be produced. If more of the commodity is produced, then there is a decrease in the price, and vice versa for a decrease in the production of a commodity. This is the basic idea of supply and demand. The main point here though is the idea of equilibrium, which is what determines a commodity’s “true” cost.
When a government wants to generate revenue, or maybe they want to decrease the purchasing of an item like cigarettes, they will implement a tax. The tax is figured into the price that the consumer pays. This tax effectively increases the price, which in turn forces the producer to sell less of the commodity. Nevertheless, that is not the only damage that occurs in the market. The consumer and the producer share the burden of the tax created.
On the graph we can see that the equilibrium price for a pinckney is $20. When the government implements a $16 tax (sections B & D), the equilibrium price becomes $28. This creates a pocket of lost revenue that no one gets (sections C & E). This is the deadweight loss created by the tax. The question here is how much revue was lost due to the tax? The formula for this example is very basic. All we have to do I find the area of a triangle; A = (b*h)/2. However, most real world scenarios would require a greater understanding of calculus.
A = (2*16)/2
A = 16
This means that there is a loss of $16 and two less pinckneys available on the market. Not only that, but as mentioned before the pinckneys cost more to purchase. Also, if we look at the graph we can see that the producer is no longer getting paid $20 a pinckney, but now $12. For example, let’s say that tax eats the producer’s profits. They may have to shut down because they can’t operate or maybe they can’t compete. This becomes an even bigger problem if the producer has to shift more of the tax burden onto the consumer in order to stay afloat. This means that the price would go up and, therefore, would create even less of a demand.
On the other side the price rises for the consumer. This certainly hurts the poorest among us. What if a consumer can no longer afford the pinckney at $28, but could at the $20 price point? This is needlessly lost income on the side of the consumer in the form of higher prices. There is also unseen losses here. The loss of goods and services that were never created or traded because there was an artificially inflated cost of doing business. That increase in price could have went to the creation of a product or service, but now the consumer doesn’t have the revenue. Likewise, the producer has neither the extra $8, nor the added sales, to generate revenue to invest back into his company.
When the government creates a tax there is far more loss than what is realized. This tax example is exaggerated, but at the same time the principle still stands. A tax inflates the price and is passed on to both parties, or in a worst case the consumer. This raises the price, decreases the revenue, and generates a loss of opportunity in doing so.
From here we can extrapolate this concept to the mismanagement of tax revenue, which contributes to government waste. Also, when you look at all the taxes in the market, we can really begin to see that there is an immense amount of deadweight loss out there. This is lost revenue for producers and lost income for all of us.
It is important for us to understand all the repercussions of government interventions into the market. Some externalities occur and the market has to adjust. These things happen, but when it is artificially created by the state, then it is no longer the inner-workings of the market. Deadweight loss caused by taxation is a big problem that is not discussed enough, but the more we understand, the better we are able to address the problems in the market place.
Deadweight loss is simply an uncollected tax that is hidden under the collected tax. The potential to be able to have more money in both the consumer and producer’s pocket is thwarted by government attempting to capitalized on the market exchange. By the state making its move to steal revenue from both parties on a transaction that they had no part in, it creates unintended consequences like deadweight loss. However, they do not care because they didn’t lose. Instead, they made 100% profit at the expense of the people.
Read more from Rocky at Think Liberty here.