Question

Taxes are generally distortionary. This means they affect the behaviour of consumers and/or producers. If the private market would achieve a Pareto efficient outcome without the tax, then when a distortionary tax is introduced, it moves society away from the Pareto efficient outcome. In other words, it makes society as a whole worse off. The efficiency loss is known as the "excess burden" or "deadweight loss" of the tax.

Give an example of a tax and explain how it distorts consumer and/or producer decisions. Explain why this impact on consumer and/or producer behaviour might be inefficient.

Note: Be specific! Do not give a general example like "the GST makes consumers buy fewer goods" - instead, try to think of a tax on a very specific item (or at least how a general tax like the GST might affect a very specific item.

Answer 1

Taxes can be distortionary in nature. Market distortion occurs when there is a departure from the ideal of perfect competition that interferes with economic agents maximising social welfare when they maximise their own welfare.

One such example of a tax is proportinal wage income tax. Let us suppose that an individual earns $100 and is taxed at 10%. Thus, his disposable income is $90. The individual is aware that if he works more, he will also have to pay more taxes. Which is why taxes serve as disincentive for the consumer.

Due to the tax, individuals will be discouraged to work, thus reducing the labor supply. This will reduce the equilibrium level of employment in the economy. In this example, workers act as suppliers of their factor services so we can view them as producers of factor service and the employers are consumers of factor service.

This impact of tax is inefficient because this has reduced the optimal level of employment that was possible in the economy and caused unemployment.

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