Question

Taxation

a) Define the tax wedge. What does full shifting mean?

b) Why does taxation generate welfare losses?

Answer 1

Tax wedge is defined as the ratio between the amount of taxes paid by an average single worker (a single person at 100% of average earnings) without children and the corresponding total labour cost for the employer. The average tax wedge measures the extent to which tax on labour income discourages employment. This indicator is measured in percentage of labour cost.

Tax shifting means transferring some or all of a tax burden of an entity to another (for example, by a subsidiary to the parent firm, or by a producer or supplier to the consumer). The incidence of a tax rests on the person(s) whose real net income is reduced by the tax. In full shifting the entire tax burden of an entity is transferred to another.

Welfare loss of taxation refers to the decreased economic well-being caused by the imposition of a tax. It measures the effect of dead weight loss caused by a change in taxes or the tax system. Imposing taxes on any product or activity makes it less attractive and gives people less incentive to purchase or participate in it. Taxpayers not only suffer from having less money because of the tax, they also suffer because the tax may change their behavior. Taxation results in dead weight loss which results in the economy functioning below optimal levels. This loss is referred to as the welfare loss of taxation.