Last week, I wrote about what the marginal excess burden of taxation is and why it’s important. The basics of that article are that usually, we don’t count transfers in cost-benefit analysis because what counts as a benefit to one person counts as an equal cost to another. The net cost to society comes from distortions the tax and transfer system makes to the economy: incentives or disincentives for work or consumption. This is because when the government has to raise taxes in order to initiate this transfer of dollars that creates a drag on the economy that we need to account for within a cost-benefit analysis.
Today, I want to talk about how we actually calculate the marginal excess burden of taxation. Below, I presenthat steps there are and what considerations need to be taken into account when estimating the marginal excess tax burden of a policy.
Determine what indicators need to be included
In a cost-benefit analysis, it is not always obvious which indicators need to be viewed through the lens of marginal excess tax burden. In general, this should be anything that involves public dollars being spent, even in situations where a benefit or cost is not directly connected to a theoretical change in the tax code. This is because tax dollars ultimately are needed to finance these programs, and these taxes create distortions within markets.
This came up in a cost-benefit analysis we are currently working on. We are analyzing the impacts of a Universal Pre-K program in Ohio, and one of the benefits is the avoided spending on public schools as a result of fewer students having to repeat grades.
Although this benefit is not directly associated with a change in marginal tax rates (this avoided spending could in theory just be redirected to some other public school program), because we are dealing with a reduced spending of tax dollars the benefit should be the loss of the theoretical drag on the economy.
Choose a value for the marginal excess burden of taxation
Depending on what source you look at, the marginal excess burden of taxation could be as high as 75% or as low as 11%. Clearly, what value you choose can end up having a major impact on your final results. As James Hynes from the University of Michigan explains:
“A major practical difficulty in measuring the excess burden of a single tax, or of a system of taxes, is that excess burden is a function of interactions that are potentially very difficult to measure. For example, a tax on labor income is expected to affect hours worked, but may also affect the accumulation of human capital, the intensity with which people work, the timing of retirement, and the extent to which compensation takes tax-favored (e.g., pensions, health insurance, and workplace amenities) in place of tax-disfavored (e.g., wage) form. In order to estimate the excess burden of a labor income tax, it is in principle necessary to estimate the effect of the tax on these and other decision margins.”
And that is just for the marginal excess burden of income tax. We know that there are different rates of excess tax burden for different types of taxes as well.
If you know how a potential policy is going to be funded, then you should try and use an estimate for the marginal tax burden associated with the type of tax you expect to be levied. If it is unclear, then finding a median estimate is likely the best way to proceed.
Multiply
The easiest step by far when determining the marginal excess burden of taxation is calculating it. If a program is going to cost $100 and you have determined that your marginal excess tax burden is 50%, then the social cost of your program is $50.
Understanding and calculating the marginal excess burden of taxation is crucial in evaluating the true economic impact of public spending. By carefully selecting the appropriate indicators and using reliable estimates for the excess burden, we can more accurately assess the broader social costs of government programs.