Here, in Market W, S’ is the new Supply curve brought about with the increase in costs imposed on widget producers from taxation. The marginal benefits (green striped triangles) otherwise attained by marginal producers at higher cost are forgone, the resources which would have been spent to obtain those marginal benefits are instead available, and here allocated, to be expended more efficiently in Market T of the economy, the market for thingbobs,. Market T can be similarly taxed, the resources applied still elsewhere in the economy. Eventually, of course, the entire economy is made more efficient, as a portion of the otherwise inefficiently used resources in other markets are distributed to other markets, are some even eventually returned to more efficient use in the markets for widgets and thingbobs.
Now the freed resources are not actually re-allocated by government. Private enterprises, rather than trying to inefficiently compete in an unprofitable market, simply choose to place their resources in other markets where they can be used more efficiently. One can argue, of course, that they should do this anyway. But it is simply the fact that every market has marginal and inefficient producers, trying to make a dollar. The tax provides them with additional incentive to enter markets where their use of resources will be more socially efficient, where for lesser cost they provide greater welfare.
To be sure, the difference is harvested by the government. And if we examine the diagram with two markets, we see that the net benefits to the private sector are smaller, with the tax, by about the welfare society would gain from the inefficient producers. The diagrams are generic, and results will vary.
However, in the example sketched, with a tax wedge in place transforming the inefficient producers in one market into efficient producers in another, for the same cost, society gains government welfare in amount about 4 times the total welfare provided by the inefficient producers. (The direct gains in government welfare from taxing widgets replaces some of the welfare society would gain if the market in widgets were untaxed. So, for the cost of expensively produced widgets, we gain efficiently produced thingbobs, and a total of government services of value more or less equal to the value of the combined social value of the production of both widgets and thingbobs. .
Under judicious taxation, as a result of this increase in efficiency in the use of resources, most of the services of government can be provided for for free. That is, resources which would be applied in some inefficient productive process, and so largely wasted, may be applied more efficiently in providing economically useful government services. And many of the services provided by government, by eliminating many of the costs of transaction and overhead that producers would otherwise bear, also act to increase the efficiency of the private productive economy.
Inadequate taxation, and the necessary reduction in economically useful services purchased with these taxes, far from increasing the competitiveness of an economy, decreases it, and nations with an inadequate public sector are at a competitive disadvantage with respect to foreign producers in countries with more robust public sectors. Further, even with the light tax burden, the citizens of countries with small public sectors are less provided for, and are a greater burden to the industry of that country, than countries with a larger government service sector.
In the example illustrated by the diagram, without taxation the total social welfare is about twice the cost of resources expended. ( The size of the green plus the blue triangles compared to the pink triangle in the first diagram.) With the tax wedge as illustrated, the total social welfare is almost 4 times the real cost to producers. (The size of the solid green and blue regions in both markets of the previous diagram compared to the solid pink regions.)
Although we have drawn the diagram for two particular and identically composed markets, it is apparent that for a wide variety of supply and demand diagrams, and thus, for a wide variety of economic sectors, the application of a tax wedge will result in a large increase in economic efficiency.
By implication, the opportunity costs of the small amount of marginal benefits forgone are huge. The benefits forgone would be obtained by essentially wasting resources in producing them, and are a small fraction of the benefits produced by allocating these resources more efficiently. Indeed, we may expect this improvement to be even better than it initially appears, since we would expect the most marginal producers to be those most eager to externalize their costs in order to remain competitive. Pressure to externalize costs is thus also reduced on the more efficient producers. The economic results from failing to apply a tax wedge in a market are, apparently without exception, far inferior
The very pejorative “deadweight loss,” has been used by those ideologically opposed to government intervention in an economy as a justification for their position. However, they, and the economics profession as a whole, have totally over-looked the high opportunity costs involved in the creation of these marginal benefits. Taking these costs into consideration inverts the conclusion: The gain in freed resources, in almost any reasonable scenario, far outweighs any gain involved in wastefully spending these resources for these relatively small benefits. Indeed, in the scale of economic activity, these resources are much more wisely spent elsewhere. And the tax wedge causes this to happen. Far from being a burden, taxation in a market, and at what is traditionally considered a rather high level of taxation, can yield much closer to optimal economic results. .
I leave it to those ideologically opposed to government intervention to find exceptions to the tax wedge increasing efficiency. I do observe that the apparent requirement for monotonicity in the supply and demand curves would seem to make finding these exceptions difficult.
One interesting argument, though, which remains, is the argument from liberty. This argument would seem to suggest that the wanton destruction of scarce resources is, somehow, ‘liberating.’ And indeed, acquiring the ability to squander society’s resources seems to be one of the primary motives for becoming wealthy, and indeed the ability, and under capitalism the right, to squander society’s resources is the very defining characteristic of wealth. And this would seem, for example, to be the argument against higher gasoline taxes in the United States. The case shown here is that a higher gasoline tax, even with money spent (more efficiently) on public transit, would free up resources for everyone, as the European experience seems to show. To be sure, there would be less joyriding, and tickets to NASCAR events might become more expensive.
There does remain the issue of determining the balance between efficiency and quantity of production in any particular market required for the proper functioning of an economy. Considerations of scale indicate that, contrary to what is shown in the diagrams, the first unit of anything is seldom the most efficiently produced. Rather, there is an optimum scale of production, that which minimizes the average cost, (This ignores issues of demand, and thus actual profit.) and we must consider this to be true for an entire economy as well as for a particular production process. While with this consideration the improvement in economic efficiency would not be as great, it must still be expected to be impressive.
Also, it should be easier to tax economic wants as opposed to economic needs. (Although see problem three, below.) A more efficient economy, however, needs less to sustain its function and so has relatively more resources available for the servicing of wants.
“Deadweight loss” is also found in other market situations. Regulated markets, markets with price controls, and markets restricted by private actions such as monopoly formation and oligopoly usually also involve deadweight loss. Increases in efficiency should also be expected in these situations, so It would seem that these other situations also, at the least, need to be re-examined.