Education

The Seen and the Unseen: Educational Revenues and Deadweight Loss

June 3, 2014

Wendy Warcholik, Ph.D.

Jonathan Small’s article on education revenues, as dramatic as it is, only examines the direct cost of education on taxpayers. But also very significant are the indirect costs—all of the lost opportunities brought about by the very process of transferring resources from the private sector to the public sector via taxation. This is what economists call “deadweight loss.” The bigger questions then is: Do the gains from our current educational system outweigh the deadweight loss of such a high level of taxation? This article explores how to begin this important conversation.

It is well established that people respond to tax incentives and disincentives. For example, they may buy a larger house than they otherwise would because they can deduct the mortgage interest from their federal income taxes. Since the behavior is tax-induced, it harms the economy; if not for the tax break, the taxpayer would have made other choices about how to use the extra money.

“Deadweight loss” is a term used by economists to describe economic activity forgone by consumers and producers because of the higher relative price of goods as a result of the tax. Taxpayers may respond to the proposed higher tax rates by reducing their work effort, lowering their consumption, or even leaving the state in order to avoid the higher tax bill. In other words, the very process of transferring resources from the private to the public sector results in a permanent loss of current and future economic output.

The nearby chart graphically shows how economists are able to estimate deadweight losses where Quantity (Qe) and Price (Pe) show the market equilibrium. The addition of a tax has the same effect as an artificial price increase. The new price point of intersection with the Demand (P+Td) and Supply (P+Ts) curves is at Quantity (Qt). The rectangle formed by the new intersection is the revenue gained by the tax.

The resulting triangle represents the deadweight loss—the value of trade that would have occurred without the tax, but is now forgone because of the tax. Deadweight loss can be estimated by calculating the area of the triangle.

However, estimating the deadweight loss is subject to the degree to which taxpayers change their behavior. If, in fact, taxpayers buy significantly more expensive homes because the mortgage interest is deductible, then the deadweight loss is large. Economists refer to this as the “tax elasticity” (TE). The example given above is an example of “high tax elasticity.” Graphically, TE is shown by the steepness and curvature of the supply and demand curves.

Based on this standard economic methodology, Harvard economist Martin Feldstein pioneered the empirical estimations of deadweight loss. As he wrote in 1997 in the National Tax Journal:

The appropriate size and role of government depend on the deadweight burden caused by incremental transfers of funds from the private sector. The magnitude of that burden depends on the increases in tax rates required to raise incremental revenue and on the deadweight loss that results from higher tax rates. … Recent econometric work implies that the deadweight burden caused by incremental taxation (the marginal excess burden) may exceed one dollar per one dollar of revenue raised, making the cost of incremental government spending more than two dollars for each dollar of government spending.

In two exhaustive studies (National Bureau of Economic Research working papers published in 1993 and 1995), Feldstein finds, based on actual taxpayer behavior derived from IRS data, that the TE is 1.28. That is, a 1 percent change in marginal tax rates yields a 1.28 percent change in taxable income.

OCPA research fellow Wendy P. Warcholik (Ph.D., George Mason University) formerly served as an economist at the U.S. Department of Commerce’s Bureau of Economic Analysis, and was the chief forecasting economist for the Commonwealth of Virginia’s Department of Medical Assistance Services. She is a co-creator (with J. Scott Moody) of the Tax Foundation’s popular “State Business Tax Climate Index.”