Deadweight Loss of Taxation: Causes, Measurement & Example

Deadweight Loss of Taxation:

The net economic losses or the reductions in the governmental revenues from an inefficient allocation of resources are termed as Deadweight Losses. It is a common problem faced by any type of economy. It is also known as Allocative inefficiency.

The common causes of deadweight loss can be a Monopoly in pricing by the government, due to taxes and subsidies, due to price ceilings or floors on commodities and wages, special policies of the government, etc., which are discussed in detail further.

Deadweight loss can be diagrammatically explained as follows:

Causes of Deadweight Loss:

There are many causes of deadweight loss in an economy. Some of them are as follows:

1. Price Ceilings: Price Ceiling is the maximum limit set by the government for the commodity and service prices, above which any dealer could not charge from the general public. For example, the Government usually sets a ceiling on the rent as a rent control measure.

2. Price Floors: Price Floors is the minimum limit set by the government for the commodity and service prices, below which any dealer/ seller should not charge so as to avoid inefficiency in distribution. For example, this type of control is usually set on labour force hourly wages to safeguard the interest of labour.

3. Taxes: Taxes are the government charges which they charge to render the services. For example, Sales tax, Commodity tax, Income tax, etc.

Measures to Calculate Deadweight Loss:

To calculate Deadweight Loss:

Step 1: Analyze the four basic parameters, namely

1. P1 that is the original price of the commodity being valued.
2. P2 that is the new price of the commodity post imposition of price ceiling, price floor or taxes.
3. Q1 that is the original quantity demanded of the commodity being valued.
4. Q2 that is the new quantity demanded of the commodity post imposition of price ceiling, price floor or taxes.

Step 2: Calculate through the formula of deadweight loss as follows:

Dead Weight Loss=0 .5*(P2-P1)*(Q1-Q2)

Example of Deadweight Loss:

Example: The government has imposed a tax on coffee. Arun paid Rs 4 before tax for a cup of coffee, but now he pays Rs 5 for the same. This increase in price has reduced Arun’s consumption of coffee from 5 coffees a day to 3 coffees per day.

Now, to determine the deadweight loss:

Deadweight Loss=0.5*(P2-P1)*(Q1-Q2)

Deadweight Loss=0.5*(5-4)*(5-3)

Deadweight Loss=0.5*1*2

Deadweight Loss=Rs 1

So, from the above example, it can be seen that an increase in the price of a commodity due to a change in government taxes can lead to a certain deadweight loss.

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