In my past post on cigarette tax, I argue that one should not ignore the purpose of taxing a good when using economics to analyze problems. In fact, policy objective is so important that, when it is ignored, almost all economic analysis on taxes will simply lead to ridiculous results. Sadly, to my understanding, this is exactly ignored in the way we normally teach economics students.
What normally we will teach economics students (high school students in particular) about tax? Answer: tax burden and deadweight loss. Normally a demand-supply diagram is presented. A tax is levied on the good. Both the buyers and the sellers are said to share some burden of tax. But the consumer surplus and producer surplus are reduced by an amount greater than the total tax collected, so a deadweight loss is said to exist. This analysis is known to be included in DSE, GCE AL, IB etc.
While this is widely taught, the following question is rarely asked and answered: if taxing goods generates deadweight loss, why should we tax goods from the very beginning? If this question is not answered, students might be misled when learning this analysis.
Why they will be misled? This is because deadweight loss is also taught in another occasion: monopoly. Students are often taught that monopoly generates deadweight (because it charges too high a price and produces too low a quantity) when compared to a perfectly competitive firm. In this context, a policy suggestion is often explicitly given: as a monoply generates a deadweight loss, it should be regulated or broken up into smaller firms in order to eliminate the deadweight loss.
Hence, whenever deadweight loss exists, it should be eliminated, or at least reduced. But should we? Should we eliminate the deadweight loss due to taxation of goods? If so, how to? Well, if we don't tax goods, there will be no deadweight loss. So, the suggestion appears to be to avoid taxing goods. But should we?
You may answer "yes". But then the government will have no money to spend. What about simply avoiding taxing goods but taxing only income? In fact, students have never been taught in high school that taxing income also generates deadweight loss. If this is true, the method is good enough.
But what is not taught does not mean it is true. If income tax generates no welfare loss but commodity tax will, it is reasonable that all countries should rely only on income tax. But the premise of this suggestion is of course not true. Taxing income also generates welfare loss: higher income tax induces productive persons not to work so hard as they would rather enjoy more leisure than working hard to earn so little (after tax).
Another drastic answer may be: eliminating all taxes should be done. Though the government may then have no money to spend, this is a good thing. Some extreme free-market supporters, who hate any government activities, will find this answer good enough. But is it the purpose for us to teach deadweight loss? We don't tell students the purpose of taxing goods but tell them the welfare cost (deadweight loss) of taxing goods. Is it because our hidden agenda is to support minimum government? I don't think this is the teachers' or the curriculum designers' intention. But if we leave the purpose untouched, the unintended consequence will really become in line with free-market advocates' political agenda. In fact, in the same curriculum, we often also teach students the functions of a government, such as providing public goods (e.g. national defense). In other words, we assume some government expenditure must be involved. If so, the question should never be about eliminating all taxes, cutting off the source of revenue. The question should be how to collect taxes.
Thus, we have to make clear why goods are taxed and why deadweight loss is taught. The answer for the former is obvious: the government need money to finance its expenditure (e.g for public goods). However, its financing, mainly via taxation, almost always generates welfare cost, namely deadweight loss. So, the answer to the second question involves how we should use the concept. In fact, if the benefit of government (e.g. providing public goods) is always lower than the cost of government (deadweight loss), we cannot but support the extreme free-market position: let's avoid asking government to do anything for us. So, the necessary implicit assumption for the existence of a government must be: its benefit is higher than the cost. Then, the question is not to eliminate all the deadweight loss, but choose a way to minimize it. The deadweight loss analysis is useful in the sense that it enables us to judge taxing which good generates more or less deadweight loss. The policy suggestion should be to choose the tax that generates smaller deadweight loss. One should not misunderstand that the analysis of deadweight loss is to justify elimination of it as this simply means elimination of a government.
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