THE DEADWEIGHT LOSS DEBATE

Supply, demand, elasticity, deadweight loss—all this economic theory is enough
to make your head spin. But believe it or not, these ideas go to the heart of a profound
political question: How big should the government be? The reason the debate
hinges on these concepts is that the larger the deadweight loss of taxation,
the larger the cost of any government program. If taxation entails very large deadweight
losses, then these losses are a strong argument for a leaner government
that does less and taxes less. By contrast, if taxes impose only small deadweight
losses, then government programs are less costly than they otherwise might be.
So how big are the deadweight losses of taxation? This is a question about
which economists disagree. To see the nature of this disagreement, consider
the most important tax in the U.S. economy—the tax on labor. The Social Security
tax, the Medicare tax, and, to a large extent, the federal income tax are
labor taxes. Many state governments also tax labor earnings. Alabor tax places a
wedge between the wage that firms pay and the wage that workers receive. If we
add all forms of labor taxes together, the marginal tax rate on labor income—the
tax on the last dollar of earnings—is almost 50 percent for many workers.