The Excess Burden of Taxes and the Economic Cost of High Tax Rates

When it comes to tax policy, the emphasis in Washington, DC, has once again turned to how to split up the economic pie rather than the effect of tax policy on the size of the pie. During the 2008 Presidential campaign, the focus on equity took the form of rolling back the Bush tax cuts—increasing the top tax rates—for those with incomes above $250,000. More recently, some policymakers have wanted to go even further by adding on a high-income surtax to partially finance health care reform, which would raise the top tax rate to more than 46 percent.

Making sure the tax burden is spread in a fair and equitable way clearly has popular and political support. But "fairness" is highly subjective. The current tax system is already highly progressive, with roughly two-thirds of all federal income taxes paid by the top 5 percent of taxpayers. Nevertheless, as income gains are not necessarily spread evenly across the population, the distribution of the tax burden is routinely adjusted through the political process.

What is surprising, however, is that the economic cost of some of the policies designed to increase progressivity—in particular, further increases in tax rates—is seemingly absent from the policy debate. High tax rates affect many decisions made by households and businesses. A basic tenet of sound tax policy is to balance distributional objectives with the distortive effects of high tax rates rather than disregarding one or the other.

This report estimates the economic cost of higher tax rates, what economists often refer to as the "excess burden" or "deadweight loss" of taxes. It represents the loss in welfare over and above what people transfer to the government as taxes. Virtually every tax creates an excess burden. Taxes distort choices and steer resources away from their best and highest use based purely on economic merit. When decisions are made in part for tax reasons, economic resources are wasted. The crucial point is that the revenue the government collects understates how much worse off an individual is because of a tax.

This report finds that the excess burden of taxes can be quite high, especially when the additional excess burden of higher tax rates is compared to the additional revenue raised.