Clarifying the Analysis of Deadweight Loss from Taxation

Abstract

Abstract The standard microeconomic analysis of taxation suggests that excise taxes on goods with a price-inelastic demand are more efficient in that they lead to a lower deadweight loss than taxes on goods with price-elastic demand. This argument ignores secondary effects on the rest of the economy. By narrowly focusing on the primary effects on the market where the tax is raised, the overall deadweight loss is underestimated when demand is price-inelastic. Moreover, it is overestimated when demand is price-elastic. This puts into question the validity of the standard textbook argument. In this paper we address this issue by considering how taxes affect consumer behavior in other markets. From this we can clearly see how the impact of an excise tax is not limited to one market in isolation, but is spread over all markets and affects the demand for cash balances. We suggest a simple way to incorporate this important insight into a standard textbook exposition.