Question

What is the efficiency loss ratio of a tax? How is it used in designing a tax?

Answer 1

The efficiency loss ratio of a tax: efficiency loss is the loss of welfare in the economy due to the taxations. The imposition of taxes creates dead weight loss in the economy which is the loss of efficiency or welfare. The efficiency loss is measured by subtracting sum of consumers’ surplus and producers’ surplus from the tax collected. The higher the difference the larger the efficiency loss and lower the difference smaller the efficiency loss.

The efficiency of a tax can be measured by the changes in consumers’ demand and producers’ supply of the commodity.     

The efficiency loss ratio is used in designing tax: as the calculation of efficiency loss ratio tells us that how much the tax is beneficial for economy and how it is going to affect the welfare of the economy. Through this ratio we get to know that how the tax is going to change demand for consumers and supply of producers and how much the surplus will reduce due to the imposition of a tax. So by analyzing all this government decides wither to apply the tax or not, how much tax rate we should keep etc.