- Email: [email protected]
The non-tax wedge
Journal
of Public
Economics
The non-tax
53 (1994) 419433.
North-Holland
wedge
Edgar K. Browning* AFed
F. Chalk Professor of Economics, Texas A&M University, College Station, TX 77843, USA
Received November
1991, final version
received October
1992
This paper argues that there are a large number of non-tax phenomena that have the effect of reducing input prices below marginal value products, just as do taxes on income. It is shown that the presence of the ‘non-tax wedge’ between the marginal value product of labor and the net wage is highly significant for the analysis of the total and marginal welfare costs of taxes. (Similarly, the presence of the tax wedge is significant for the analysis of the welfare effects of the non-tax phenomena.) Welfare costs are substantially higher when appropriate account is taken of tax and non-tax wedges that both distort supply decisions.
1. Introduction In the familiar analysis of the welfare cost of a tax on labor income, it is always assumed, usually implicitly, that the market wage in the absence of the tax is equal to the social marginal value product of labor. In reality, however, there are a number of non-tax market imperfections that imply market wages would be below marginal value products even in the absence of taxes. These include such things as monopoly, monopsony, theft by employees and consumers, pollution controls, and many forms of business regulation (with qualifications noted below). How these non-tax phenomena that depress wage rates interact with tax policies that have the same effect is the focus of this paper. It will be shown that the existence of non-tax labor supply distortions is highly significant for the analysis of the welfare effects of taxes falling on labor income. Of equal interest is the fact that the welfare effects of the non-tax phenomena are also dependent on the simultaneous presence of tax policies.
2. The non-tax wedge There exist a large number of non-tax market imperfections which, when examined in a general equilibrium context, have among their effects the Correspondence to: Professor Edgar K. Browning, Texas A&M University, College Station, TX 77843, USA. *The author wishes to thank participants in the Public/Labor Workshop at Texas A&M and two referees for helpful comments on earlier versions of this paper. 0047-2727/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDI 0047-2727(93)01361-D
E.K. Browning, The non-tax wedge
420
OY Fig.
I
depressing of market wage rates below social marginal value products (MVPs). To illustrate the general point, assume that all markets are perfectly competitive except for the particular imperfection being examined. Two products, X and Y, are produced using as inputs labor and capital, L and K. The total quantities of inputs are initially assumed fixed to permit a simple graphical treatment. Basically, this is the world of Arnold Harberger’s general equilibrium model [Harberger (1962)], which has been widely used for tax policy analysis.’ In fig. 1, the horizontal axis measures the (fixed) total quantity of labor which is allocated to the production of X and Y. The demand curves for labor are shown as D, and D,,drawn relative to their respective origins. These demand curves reflect the (social) marginal value productivity of labor in each industry. Under conditions of perfect competition, labor is allocated between X and Y so that wage rates, and hence MVPs, are equal. Thus, initially we have O,L1 employed in X at wage rate wx and OyL, employed in Y at wage rate wy. Now let us examine the effects of a government regulation requiring firms to provide safety equipment to workers at a cost of $Z per hour. This regulation causes the industry demand curves for labor to shift downward by $Z to D; and D;,reducing the wage rates paid to workers in both industries ‘The graphical (1975).
treatment
used in this section
is based on the analysis
in McLure
and Thirsk
E.K. Browning, The non-tax wedge
421
of labor remains by $Z so they become wZ and wk. The allocation unchanged at L,. We now need to consider whether this regulation distorts the labor supply decisions of workers in the same way as a tax of $Z per unit of labor would. With the regulation, the social MVP of workers remains unchanged at w, but the market wage paid to workers falls short of w by $Z. Workers, however, may not now treat w as their real marginal compensation since additional labor effort brings them not only w but also additional safety equipment. How workers will respond, therefore, depends crucially on the value of the additional safety equipment. If they value it at zero, then labor supply will adjust so that the marginal rate of substitution (MRS) is equated to w’ and so falls short of the social MVP. In that case, the regulation produces the same distortion as a tax on labor income. On the other hand, if they value it at $Z, the MRS is equated to w’ plus $Z, and so is still equal to the social MVP: no labor supply distortion. Intermediate outcomes are also possible, of course.’ This example was constructed to emphasize the important point that even though some institution or policy does depress market wage rates, it does not necessarily follow that labor supply decisions are distorted. The possibility that labor supply is not distorted arises in several of the phenomena I refer to in this section, and I will not try to evaluate empirically the extent to which a distortion is or is not produced. That determination often requires evidence that is not available, and in view of the number of phenomena involved lies beyond the scope of this paper. Returning to the example, assume that workers place no value on the safety equipment. Then the policy leads workers to adjust their labor supply to w’ while w is the social MVP; the difference is $Z. I will refer to the difference when expressed as a percentage of the MVP (i.e. Z/w) as a non-tax wedge, by analogy to the familiar tax wedge from public finance theory. The non-tax wedge acts as a hidden marginal tax rate on labor, and has the same allocative significance as a tax on labor at that rate, as will be made clear in the next section. In this example, it was assumed that the non-tax wedge was proportionate to employment in both markets and so did not change relative product prices. Of course, for many types of non-tax market imperfections we would expect relative prices to be affected. Monopoly is an example. Most analyses of monopoly emphasize exclusively the distortion in relative product prices
2Determining how much of the reduction in the wage rate constitutes a distortion is not a problem unique to non-tax phenomena; it exists also for some taxes. For example, to the extent that workers view social security payroll taxes as simply savings that will be returned to them later as pensions, the payroll tax does not distort the labor supply decision. On this topic, see Burkhauser and Turner (1985) and Browning (1985).
1.P.E.p
D
’422
E.K. Browning,
The non-tax wedge
which leads to an inefficient output mix. But monopoly also affects total resource supplies since monopoly profits enter as a wedge between product and input prices. In terms of input markets, labor and capita1 are paid less than their MVPs in the monopolized markets, while they are still paid their MVPs in competitive markets. Thus, the wage rate is below the (weightedaverage) marginal value product of labor for the economy. Where the non-tax wedge does not affect all markets proportionately (as is presumably the case for monopoly), in some instances it will have the same effect on labor supply as a proportionate tax on labor earnings. For example, if good X is monopolized and good Y is not, but the two goods are consumed in fixed proportions, monopoly will affect labor supply in exactly the same way as a tax on labor earnings at a rate equal to monopoly profits as a percent of national income. (Recall that in the fixed proportions case, an excise tax on X is equivalent to a genera1 income tax, and monopoly is analytically equivalent to an excise tax.) In the next section I will evaluate the labor supply effects of non-tax wedges as if they were proportionate distortions in all markets, and so equivalent to proportional income taxes. It must be emphasized that this approach will not always be correct (although it would be with consumption in fixed proportions), as has been clear since the seminal work by Corlett and Hague (1953-1954). In general, the welfare costs of phenomena affecting both relative product prices and the income-leisure choice depends on the precise ways the various goods enter utility functions. The approach I will use ignores the relative product price distortion, but it may also understate or overstate the distortion in the income-leisure choice. It would overstate the income-leisure distortion, for example, if the monopolized good was complementary to leisure. On the other hand, it could equally well understate the distortion. For that reason, as well as the absence of detailed evidence regarding how goods with large non-tax wedges enter utility functions, it seems reasonable to assume that non-tax wedges in the aggregate affect labor supply as would proportionate income taxes.3 As the examples of monopoly and regulation probably suggest, there are many non-tax market imperfections that operate to depress input prices below MVPs when analyzed within a genera1 equilibrium context. How large the resulting non-tax wedge is in the aggregate is quite important for several issues in policy analysis, as shown in the next section. In an effort to suggest the likely order of magnitude of the total non-tax wedge, table 1 gives
-‘It should be noted that the treatment I will use - treating an input market distortion in a subset of all markets as if it were a general input market distortion - is in wide use in the deductions and analysis of income taxes. Real world income taxes, because of numerous exclusions, do not leave relative product prices unchanged, yet the conventional analysis of these taxes treats them as if they did.
423
E.K. Browning, The non-tax wedge Table Direct non-tax
1
costs as a percent
Non-violent crimes against business Monopoly Unions International trade restrictions Pollution control Federal regulation of business
of NNP. 1.6 3.0 2.5 1.6 2.0 3.8 15.7
Sources: Weidenbaum (1979, p. 23) Scherer (1980, p. 471). Hollinger and Clark (1983, p. 2). Hirsch and Addison (1986, p. 153). Hufbauer et al. (1986, Table 1.4) Blinder (1987, p. 153).
estimates of the relevant costs of several major non-tax market imperfections, with the costs given as percentages of net national product. (This treats the costs as if they were equiproportionate levies on both capital and labor, although in the next section I will examine only the labor supply consequences.) Table 1 suggests that the aggregate non-tax wedge may be on the order of 15.7 percent, i.e. wage rates would be 15.7 percent below MVPs even in the absence of taxes. It should be iterated, however, that this does not mean that all of these phenomena necessarily distort labor supply choices. This is particularly relevant to keep in mind when considering government policies. For example, pollution policies, if they were to effectively mimic the ideal pollution taxes favored by economists, would actually tend to bring input prices into line with social MVPs and would constitute no distortion at all. Treating the cost of pollution controls as fully distorting therefore probably overstates their effect, but by how much is far from clear. Thus, the aggregate non-tax wedge is probably overstated for the phenomena included in table 1. On the other hand, there are a large number of other phenomena which are not included in the table (because I could not find appropriate aggregate cost estimates). These include state and local regulations, rent controls, agricultural price supports, product liability costs, and so on. Including these would increase the estimated aggregate non-tax wedge. Thus, on balance, it is not clear whether the 15.7 percent figure overstates or understates the non-tax wedge. For that reason, I will use a range of values from 10 to 20 percent for the non-tax wedge in the illustrative calculations in the next section.
3. Tax and non-tax interactions This section uses the familiar partial equilibrium model of labor supply to investigate how tax and non-tax factors interact to determine three types of
424
E.K.
Browning,
The non-tax
wedge
Fig. 2
welfare costs, and to provide rough estimates of taking account of the non-tax wedge.
3.1.
of the quantitative
significance
The total welfare cost
In fig. 2, a representative worker’s social marginal value product is equal to w, the wage rate that would guide the labor supply decision in the absence of all tax and non-tax wedges. There is a non-tax wedge of n (expressed as a percentage of w), implying that the market wage rate would be w( 1 -n), or WI, even in the absence of taxes. However, now assume that there is also a tax on market earnings that applies at a murginal rate of m; this rate applies to market earnings net of the non-tax wedge, that is, labor supply valued at the marginal net wage rate confronting the worker is W’. Thus, w( 1 -n) (1 -m), or wi. The combined effect of the non-tax and tax wedges is to reduce the net wage below the MVP by (n+m-nm), expressed as a percentage of w. I will refer to (n +m-nm) as the total wedge, or T; note that it is less than the sum of the tax and non-tax wedges because the tax base is less than the MVP. The worker supplies L, hours of work at the net wage wi. Let S* be the compensated labor supply curve through the equilibrium point. Then the total welfare cost due to undersupply of labor is equal to the triangular area shown in fig. 2 as the sum of areas A and B. This welfare cost can be
E.K.
Browning,
The non-tax
expressed in a simple algebraic form labor supply curve is linear. Then the where dL is the compensated change familiar substitutions [see Browning expressed more conveniently as
wedge
425
if we assume that the compensated welfare cost is equal to (1/2)(dL)wT, in labor supply, Lo-L,. After some (1987)] the welfare cost, W, can be
where v is the compensated labor supply elasticity. Note that T replaces the marginal tax rate in this familiar formula since the welfare cost depends on the combined tax and non-tax wedge. Note also that eq. (1) evaluates labor earnings at the MVP, which is higher than the market wage by a factor of 1/(1-n). As mentioned earlier, estimates of this labor supply distortion have previously neglected the non-tax wedge. In terms of fig. 2, traditional estimates of the welfare cost of labor income taxation have produced estimates of area A by assuming that the market wage rate, w’, was equal to the MVP. This procedure understates the true welfare cost, which equals areas A+ B. The magnitude of understatement depends on the sizes of the tax and non-tax wedges and the compensated labor supply elasticity, as indicated in eq. (1). To put some perspective on the magnitude of understatement, I will use eq. (1) with aggregate U.S. data. Browning (1987) provides a discussion of the basis for selection of values for m and ‘1. Based on that discussion, I will use my preferred estimate of m of 43 percent4 For the compensated labor supply elasticity, interpreted as a weighted-average value, I will use a range of values (0.2, 0.3, and 0.4), since there is greater uncertainty about the appropriate value of this parameter. For the non-tax wedge it, the value suggested by the previous section is 0.15; I will also use values of 0.1 and 0.2 given the admitted imprecision of the estimate there. Finally, for aggregate labor earnings I use a value of $3,016 billion, based on figures for 1987.’ Note that this value for labor earnings corresponds to w’L, in fig. 2. To convert this figure to wL, as required by eq. (l), we multiply by l/(1 -n), a conversion factor that will vary with the value of n used. Based on these values, table 2 gives estimates of the total welfare cost in “This estimate is based on 1976 data, and is explained in Browning and Johnson (1984). Although there have been many changes in tax and transfer policies since 1976, I doubt that the weighted-average marginal tax rate has changed significantly. It is worth noting that the overall average tax rate (total tax revenues as a percent of GNP) has risen from 30.7 percent in 1976 to 32.0 percent in 1989. 5This is based on the Economic Report of the President (1989, Table B-24). which gives $2,683 billion as total compensation of employees. To this I have added adjustments for proprietors’ income and sales and excise taxes.
426
E.K. Browning,
The non-tax
wedge
Table 2 Total welfare cost (% billion).
\n 4 ~~~ 0.2 0.3 0.4
O \
~~~ 91.8 146.8 195.7
0.1 ~ 155.0 232.4 309.9
0.15
194.6 291.9 389.1
0.2
244.6 367.0 489.3
1987. For my preferred values of q (0.3) and n (0.15), the welfare cost is $291.9 billion, about 10 percent as large as total labor compensation6 Of greater interest is the importance of taking account of the non-tax wedge. Note that if the non-tax wedge is assumed to be zero (n=O), as implicitly assumed in all analyses of the welfare cost of taxation, the welfare cost estimated is only half its true value when n=0.15. Even if n is only equal to 0.1, the actual welfare cost is more than 50 percent larger than estimated by the conventional analysis. Previous estimates of labor supply distortions in the U.S. economy may therefore have significantly underestimated its true magnitude.
3.2. Marginal
werfhre cost of taxation
Although the total welfare cost of taxation alone is ambiguous when there are several tax and non-tax wedges, the marginal welfare cost of a specified change in the tax structure can be meaningfully estimated. Indeed, for the purpose of expenditure policy analysis it is the relevant measure of the welfare cost of taxation. Marginal welfare cost is the additional welfare cost due to the tax change per dollar of additional revenue generated, and it measures the amount that must be added to the direct cost of taxation (the revenue raised) to measure the social cost of funding the expenditure. (The term ‘marginal cost of funds’ is often used to mean the social cost of taxation per dollar of revenue; it equals one plus the marginal welfare cost.) Several estimates of the marginal welfare cost of taxation can be found in the literature [Stuart (1984), Wildasin (1984), Ballard et al. (1985) and Browning (1987)]. Fullerton (1991) has recently pointed out that several different definitions of marginal welfare cost (or marginal cost of funds) underlie these estimates. Most writers [for example, Ballard and Fullerton (1989) and Mayshar (1990, 1991)] argue that the most appropriate definition relies on the uncompensated change in labor supply induced by the tax rate change. I am in the minority in believing that the better definitions are the “Several caveats concerning cost are discussed in Browning
the accuracy (1987).
of this partial
equilibrium
estimate
of total
welfare
IX.
w1
Browning, The non-tax wedge
427
C
*2-
L2 Ll Fig. 3
ones that rely on the compensated change in labor supply, but all agree that there are cases when the compensated approach is appropriate. For example, when the expenditure policy being funded provides benefits to taxpayers that are a perfect substitute for the disposable incomes of taxpayers, use of the compensated labor supply curve to estimate marginal welfare cost is the correct approach [see Browning (1987)]. I will use the compensated approach here, but it should be emphasized that alternative approaches may be preferable for evaluating some types of expenditure policies. With that caveat in mind, consider fig. 3. The worker initially confronts a marginal tax rate of m and a net wage rate of wi, so labor supply is L,. Initially, I will assume that the tax is a proportional one so that the marginal and average rates are the same. Now the tax rate must be raised to m' to fund a specific expenditure policy. This reduces the net wage to w2 and labor supply declines to L, along the compensated labor supply curve. As a result, the welfare cost triangle increases by areas A+B, while tax revenue increases by areas C-B.’ The added welfare cost per dollar of revenue is thus (A + B)/(C - B); this is the marginal welfare cost. To suggest the quantitative significance of the non-tax wedge for the
‘1 am assuming that the non-tax wedge involves transfers to other people, just as the tax wedge involves transfers to government. Then when the tax rate increases, area A is a loss to those previously gaining, just as area B is a loss to the government.
428
E.K. Browning,
The non-tax wedge
marginal welfare cost of taxation, note that the additional is equal to wTdL, and dL equals qL, dm/( 1 -m). Thus, dW=
welfare cost, d W,
wT ‘I& dm.
(2)
ri
Additional revenue from the increase in the tax rate equals w’L, dm + w’mdL, which can be written as
welfare cost, M, is dW/dR,
Marginal
M=
lbT 1 _
‘?m
area
C-B,
or
or (after simplifying)
(4)
l-m This derivation’ is based on the assumption that the tax is proportional. ._ _ When the tax, or more precisely the tax change that generates the additional revenue, is non-proportional, the additional revenue is w’L, dt + w’m dL. The dt term is the change in the average tax rate which is now permitted to differ from the change in the marginal rate, dm. The added welfare cost is still determined exclusively by the change in the marginal tax rate, as in eq. (2). In this case, after some simplifications, marginal welfare cost is found to be
“0,
ME---!-T dt
(5)
In eq. (5), the dm/dt term measures the progressivity of the change in the tax structure that generates the added revenue. For a proportional change (even if the initial tax structure is progressive), dm/dt equals one, and eq. (5)
‘As mentioned previously, several economists prefer an approach in which uncompensated elasticities play the critical role. When this is the appropriate approach, eq. (4) can be used, but with q now interpreted as the uncompensated elasticity. [Eq. (4) can be derived from Mayshar’s (1991) eq. (3) by setting dm/dt equal to one and y equal to zero, but with m replacing 7’ in the numerator since Mayshar does not consider the non-tax wedge.] Two points are noteworthy. First, marginal welfare cost will be smaller when the uncompensated elasticity is used since it is less than the compensated elasticity. Second, marginal welfare cost will still be larger when a non-tax wedge is present (so T>m), just as is true in the compensated case.
429
E.K. Browning, The non-tax wedge Table 3 Marginal welfare cost of taxation (percentages). n
0
0.1
0.15
0.2
dm/dr\ 1.0 1.39 2.0
29.3 45.9 82.7
36.8 57.8 104.1
41.3 64.7 116.6
46.3 72.6 130.8
becomes eq. (4). Marginal welfare cost is larger the more progressive is the change in the tax structure, i.e. the larger is dm/dt. To use eq. (5) to estimate M, in addition to parameter values previously discussed we require dm/dt. I will use values of 1.0, 1.39, and 2.0 for dmfdt for reasons explained in Browning (1987). Table 3 shows how marginal welfare cost depends on dm/dt and the nontax wedge. (q equals 0.3 and m equals 0.43 for all the estimates in the table.) It is clear that ignoring the non-tax wedge (setting n=O) can lead to a substantial underestimate of the marginal welfare cost of taxation. With dm/dt equal to 1.39 and n =0.15, marginal welfare cost at 64.7 percent is 40 percent higher than the measure obtained on the assumption that only the tax system distorts labor supply decisions.g
3.3. Marginal
werfare cost of non-tax
distortions
The marginal welfare cost of a non-tax distortion can be defined as the additional welfare cost produced by a change in the non-tax wedge relative to the direct cost of the change in the non-tax wedge. Analogously to the case of taxation, this marginal welfare cost should be added to the direct cost of the non-tax wedge to arrive at the social cost of the non-tax phenomenon. It should be recalled, however, that I am examining only the distortion in the income-leisure decision here. Thus, the marginal welfare cost of monopoly, for example, as here considered, does not include the output mix distortion that is generally estimated. In general, the welfare cost of the output mix distortion would have to be combined with the marginal welfare cost derived here to obtain the relevant social cost measure. To evaluate a change in the non-tax wedge, assume that n increases to n’. In fig. 4, the direct effect of this is to reduce the market wage from w’ to w”. Since taxes apply to the market wage, the increase in n reduces the net wage ‘For purpose of comparison, suppose the uncompensated approach is relevant (as discussed in the previous footnote), and the uncompensated labor supply elasticity is 0.10. Then, from eq. (4), with a proportional tax, marginal welfare cost is 9.7 percent when n=O, and 13.8 percent, more than 40 percent higher, when n=0.15.
430
E.K. Browning,
The non-tax wedge
Fig. 4
from w’( 1 -m) to w”( 1 -m), i.e. from wi to w2, and labor supply falls from L, to L,.Area D is the direct cost of this change in the non-tax wedge, and areas A + B has been added to the welfare cost triangle. However, there is an additional cost in this instance because the government has lost tax revenue due to the lower wage rate and the lower quantity of labor. The reduction in tax revenue is given by D + B- C. The easiest way of taking account of this element of the cost is to assume that government increases tax rates so as to recover the lost revenue. Note, however, that increasing tax rates adds an additional element of welfare cost, the marginal welfare cost of taxation, as explained in the previous section. Thus, increasing the non-tax wedge directly adds B + A to the welfare cost, and indirectly adds M(D + B - C) as the social cost of the lost tax revenue. The marginal welfare cost of the non-tax wedge is therefore (A + B)/Dplus M(D+B-C)/D. Since A + B equals wTdL and D equals wL,dn, the first term simplifies to TV/( 1 -n). For the second term, B equals (w’-w,)dL and C equals (wz- w,)L,, so (D+ B--)/D simplifies to m(1 +r]). Therefore, the marginal welfare cost of the non-tax wedge, M,, equals: M.=z+M(rn[l
+n]).
In using eq. (6) to estimate the marginal welfare cost of the non-tax distortion, it should be kept in mind that the value of M depends on how
E.K.
Browning,
The non-tax
431
wedge
Table 4 Marginal \
\.
welfare cost of non-tax
n
dm/dt 1.0 1.39 2.0
0
0.1
29.3 38.6 59.1
36.8 48.5 14.4
distortion
(percentages).
0.15
0.2
\ 41.3 54.4 83.4
46.3 61.0 93.5
the tax system is changed to recoup the lost revenue and on other parameter values, as shown by eq. (5). With that in mind, table 4 gives estimates of M, for the parameter values used previously in table 3. Aside from the general implication in table 4 that the marginal welfare cost of non-tax distortions is quite substantial, two additional points should be made. First, note that the estimates in the first row of table 4 are the same as in the first row of table 3. This simply means that if the lost revenue is recouped with a proportional tax change, M, is the same as the marginal welfare cost of taxation for a proportional tax change (other parameter values the same, of course). This makes good intuitive sense since an increase in the non-tax wedge by itself has the same welfare implications as adding a proportional tax, so if the indirect effect from recouping lost revenue also uses a proportional tax, the total effect will be the same. The remainder of the estimates in table 4, however, are smaller than the corresponding figures in table 3. This is because they are in effect a weighted average of the marginal welfare costs of proportional and progressive (dm/dt greater than one) tax changes. Second, it should be recalled that M, compares the added welfare cost of the non-tax wedge with the direct cost of that wedge. For example, in the case of monopoly this means that the marginal welfare cost is a percentage of monopoly profits, not of the conventional welfare cost of monopoly. Using the value of M, based on dm/dt = 1.39 and n=0.15, along with the estimate of monopoly profits of 3 percent of NNP from table 1, the marginal welfare cost from the added labor supply distortion of monopoly is in excess of 1.5 percent of NNP (since M, is then greater than 50 percent). Since most estimates of the conventional welfare cost of monopoly based on the output mix distortion are well below 1 percent of NNP, this suggests that the marginal welfare cost due to labor supply effects may be quantitatively more important in evaluating the social cost of non-tax phenomena than the sort of distortions normally examined. 4. Conclusion The marginal
welfare
costs
of both
tax and
non-tax
policies
and institu-
E.K. Browning, The non-tax wedge
432
tions are likely to be significantly underestimated by ignoring the interaction between the distortions produced by both phenomena. A particularly important application is to the evaluation of government regulatory policies. While economists have long recognized that regulatory policies are an alternative to expenditure and tax policies, there has been little consideration given to the evaluation of the social costs of regulation on a comparable basis. In the case of expenditure policies, it is now well recognized that the marginal welfare cost of taxation is part of the social cost of the expenditure policy. lo This paper shows that there is an analogous marginal welfare cost for regulatory policies that plays the same role in policy analysis, and that this marginal welfare cost is likely to be significant when there are preexisting tax and non-tax wedges. Since governments are increasingly turning to regulatory measures as a way of averting an increase in the budget deficit, it is important to recognize that bypassing direct tax finance does not avoid the relevant social costs. “‘As a point of interest, this is now recognized also by the federal government. The Office of Management and Budget Circular No. A-94 (15 June 1992) notes on p. 14: ‘The presentation of results for public investments that are not justified on internal grounds should include an analysis with a 25 percent excess burden. Thus, in such analyses costs in the form of public expenditures should be multiplied by a factor of 1.25 and net present value recomputed.’ I thank a referee for providing this information.
References Ballard,
C.L. and D. Fullerton,
1989, Wage tax distortions
and public
good
provision,
Working
paper. Ballard, C.L., J.B. Shoven and J. Whalley, 1985, General equilibrium computations of the marginal welfare costs of taxes in the United States, American Economic Review 75, 128-138. Blinder, AS., 1987, Hard heads, soft hearts (Addison-Wesley, Reading, MA). Browning, E.K., 1985, The marginal social security tax on labor, Public Finance Quarterly 13, 227-251. Browning, E.K., 1987, On the marginal welfare cost of taxation, American Economic Review 77, 1l-23. Browning, E.K. and W.R. Johnson, 1984, The trade-off between equality and efficiency, Journal of Political Economy 92, 175-203. Burkhauser, R.V. and J.A. Turner, 1985, Is the social security payroll tax a tax?, Public Finance Quarterly 13, 253-267. Corlett, W.J. and D.C. Hague, 1953-1954, Complementarity and the excess burden of taxation, Review of Economic Studies 21, 21-30. Fullerton, D., 1991, Reconciling recent estimates of the marginal welfare cost of taxation, American Economic Review 81, 302-308. Harberger, A.L., 1962, The incidence of the corporation income tax, Journal of Political Economy 70,215240. Hirsch, B.T. and J.T. Addison, 1986, The economic analysis of unions (Allen and Unwin, Boston, MA). Hollinger, R.C. and J.P. Clark, 1983, Theft by employees (D.C. Heath, Lexington, MA). Hufbauer, G.C., D.T. Berliner and K.A. Elliott, 1986, Trade protection in the United States: 31 case studies (Institute for International Economics, Washington, DC). Mayshar, J., 1990, On measures of excess burden and their application, Journal of Public Economics 43.2633289.
E.K. Browning, The non-tax wedge
433
Mayshar, J., 1991, On measuring the marginal cost of funds analytically, American Economic Review 81, 1329-1335. McLure, C.E., Jr. and W.R. Thirsk, 1975, A simplified exposition of the Harberger model, 1: TdX incidence, National Tax Journal 28, l-28. Scherer, F.M., 1980, Industrial market structure and economic performance (Rand McNally, Chicago, IL). Stuart, C., 1984, Welfare costs per dollar of additional tax revenue in the United States, American Economic Review 74, 352-362. U.S. Council of Economic Advisers, 1985, Economic report of the President (U.S. Government Printing Oflice, Washington, DC). Weidenbaum, M.L., 1979, The future of business regulation (American Management Association, New York, NY). Wildasin, D.E., 1984, On public good provision with distortionary taxation, Economic Inquiry 22, 227-243.
of Public
Economics
The non-tax
53 (1994) 419433.
North-Holland
wedge
Edgar K. Browning* AFed
F. Chalk Professor of Economics, Texas A&M University, College Station, TX 77843, USA
Received November
1991, final version
received October
1992
This paper argues that there are a large number of non-tax phenomena that have the effect of reducing input prices below marginal value products, just as do taxes on income. It is shown that the presence of the ‘non-tax wedge’ between the marginal value product of labor and the net wage is highly significant for the analysis of the total and marginal welfare costs of taxes. (Similarly, the presence of the tax wedge is significant for the analysis of the welfare effects of the non-tax phenomena.) Welfare costs are substantially higher when appropriate account is taken of tax and non-tax wedges that both distort supply decisions.
1. Introduction In the familiar analysis of the welfare cost of a tax on labor income, it is always assumed, usually implicitly, that the market wage in the absence of the tax is equal to the social marginal value product of labor. In reality, however, there are a number of non-tax market imperfections that imply market wages would be below marginal value products even in the absence of taxes. These include such things as monopoly, monopsony, theft by employees and consumers, pollution controls, and many forms of business regulation (with qualifications noted below). How these non-tax phenomena that depress wage rates interact with tax policies that have the same effect is the focus of this paper. It will be shown that the existence of non-tax labor supply distortions is highly significant for the analysis of the welfare effects of taxes falling on labor income. Of equal interest is the fact that the welfare effects of the non-tax phenomena are also dependent on the simultaneous presence of tax policies.
2. The non-tax wedge There exist a large number of non-tax market imperfections which, when examined in a general equilibrium context, have among their effects the Correspondence to: Professor Edgar K. Browning, Texas A&M University, College Station, TX 77843, USA. *The author wishes to thank participants in the Public/Labor Workshop at Texas A&M and two referees for helpful comments on earlier versions of this paper. 0047-2727/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDI 0047-2727(93)01361-D
E.K. Browning, The non-tax wedge
420
OY Fig.
I
depressing of market wage rates below social marginal value products (MVPs). To illustrate the general point, assume that all markets are perfectly competitive except for the particular imperfection being examined. Two products, X and Y, are produced using as inputs labor and capital, L and K. The total quantities of inputs are initially assumed fixed to permit a simple graphical treatment. Basically, this is the world of Arnold Harberger’s general equilibrium model [Harberger (1962)], which has been widely used for tax policy analysis.’ In fig. 1, the horizontal axis measures the (fixed) total quantity of labor which is allocated to the production of X and Y. The demand curves for labor are shown as D, and D,,drawn relative to their respective origins. These demand curves reflect the (social) marginal value productivity of labor in each industry. Under conditions of perfect competition, labor is allocated between X and Y so that wage rates, and hence MVPs, are equal. Thus, initially we have O,L1 employed in X at wage rate wx and OyL, employed in Y at wage rate wy. Now let us examine the effects of a government regulation requiring firms to provide safety equipment to workers at a cost of $Z per hour. This regulation causes the industry demand curves for labor to shift downward by $Z to D; and D;,reducing the wage rates paid to workers in both industries ‘The graphical (1975).
treatment
used in this section
is based on the analysis
in McLure
and Thirsk
E.K. Browning, The non-tax wedge
421
of labor remains by $Z so they become wZ and wk. The allocation unchanged at L,. We now need to consider whether this regulation distorts the labor supply decisions of workers in the same way as a tax of $Z per unit of labor would. With the regulation, the social MVP of workers remains unchanged at w, but the market wage paid to workers falls short of w by $Z. Workers, however, may not now treat w as their real marginal compensation since additional labor effort brings them not only w but also additional safety equipment. How workers will respond, therefore, depends crucially on the value of the additional safety equipment. If they value it at zero, then labor supply will adjust so that the marginal rate of substitution (MRS) is equated to w’ and so falls short of the social MVP. In that case, the regulation produces the same distortion as a tax on labor income. On the other hand, if they value it at $Z, the MRS is equated to w’ plus $Z, and so is still equal to the social MVP: no labor supply distortion. Intermediate outcomes are also possible, of course.’ This example was constructed to emphasize the important point that even though some institution or policy does depress market wage rates, it does not necessarily follow that labor supply decisions are distorted. The possibility that labor supply is not distorted arises in several of the phenomena I refer to in this section, and I will not try to evaluate empirically the extent to which a distortion is or is not produced. That determination often requires evidence that is not available, and in view of the number of phenomena involved lies beyond the scope of this paper. Returning to the example, assume that workers place no value on the safety equipment. Then the policy leads workers to adjust their labor supply to w’ while w is the social MVP; the difference is $Z. I will refer to the difference when expressed as a percentage of the MVP (i.e. Z/w) as a non-tax wedge, by analogy to the familiar tax wedge from public finance theory. The non-tax wedge acts as a hidden marginal tax rate on labor, and has the same allocative significance as a tax on labor at that rate, as will be made clear in the next section. In this example, it was assumed that the non-tax wedge was proportionate to employment in both markets and so did not change relative product prices. Of course, for many types of non-tax market imperfections we would expect relative prices to be affected. Monopoly is an example. Most analyses of monopoly emphasize exclusively the distortion in relative product prices
2Determining how much of the reduction in the wage rate constitutes a distortion is not a problem unique to non-tax phenomena; it exists also for some taxes. For example, to the extent that workers view social security payroll taxes as simply savings that will be returned to them later as pensions, the payroll tax does not distort the labor supply decision. On this topic, see Burkhauser and Turner (1985) and Browning (1985).
1.P.E.p
D
’422
E.K. Browning,
The non-tax wedge
which leads to an inefficient output mix. But monopoly also affects total resource supplies since monopoly profits enter as a wedge between product and input prices. In terms of input markets, labor and capita1 are paid less than their MVPs in the monopolized markets, while they are still paid their MVPs in competitive markets. Thus, the wage rate is below the (weightedaverage) marginal value product of labor for the economy. Where the non-tax wedge does not affect all markets proportionately (as is presumably the case for monopoly), in some instances it will have the same effect on labor supply as a proportionate tax on labor earnings. For example, if good X is monopolized and good Y is not, but the two goods are consumed in fixed proportions, monopoly will affect labor supply in exactly the same way as a tax on labor earnings at a rate equal to monopoly profits as a percent of national income. (Recall that in the fixed proportions case, an excise tax on X is equivalent to a genera1 income tax, and monopoly is analytically equivalent to an excise tax.) In the next section I will evaluate the labor supply effects of non-tax wedges as if they were proportionate distortions in all markets, and so equivalent to proportional income taxes. It must be emphasized that this approach will not always be correct (although it would be with consumption in fixed proportions), as has been clear since the seminal work by Corlett and Hague (1953-1954). In general, the welfare costs of phenomena affecting both relative product prices and the income-leisure choice depends on the precise ways the various goods enter utility functions. The approach I will use ignores the relative product price distortion, but it may also understate or overstate the distortion in the income-leisure choice. It would overstate the income-leisure distortion, for example, if the monopolized good was complementary to leisure. On the other hand, it could equally well understate the distortion. For that reason, as well as the absence of detailed evidence regarding how goods with large non-tax wedges enter utility functions, it seems reasonable to assume that non-tax wedges in the aggregate affect labor supply as would proportionate income taxes.3 As the examples of monopoly and regulation probably suggest, there are many non-tax market imperfections that operate to depress input prices below MVPs when analyzed within a genera1 equilibrium context. How large the resulting non-tax wedge is in the aggregate is quite important for several issues in policy analysis, as shown in the next section. In an effort to suggest the likely order of magnitude of the total non-tax wedge, table 1 gives
-‘It should be noted that the treatment I will use - treating an input market distortion in a subset of all markets as if it were a general input market distortion - is in wide use in the deductions and analysis of income taxes. Real world income taxes, because of numerous exclusions, do not leave relative product prices unchanged, yet the conventional analysis of these taxes treats them as if they did.
423
E.K. Browning, The non-tax wedge Table Direct non-tax
1
costs as a percent
Non-violent crimes against business Monopoly Unions International trade restrictions Pollution control Federal regulation of business
of NNP. 1.6 3.0 2.5 1.6 2.0 3.8 15.7
Sources: Weidenbaum (1979, p. 23) Scherer (1980, p. 471). Hollinger and Clark (1983, p. 2). Hirsch and Addison (1986, p. 153). Hufbauer et al. (1986, Table 1.4) Blinder (1987, p. 153).
estimates of the relevant costs of several major non-tax market imperfections, with the costs given as percentages of net national product. (This treats the costs as if they were equiproportionate levies on both capital and labor, although in the next section I will examine only the labor supply consequences.) Table 1 suggests that the aggregate non-tax wedge may be on the order of 15.7 percent, i.e. wage rates would be 15.7 percent below MVPs even in the absence of taxes. It should be iterated, however, that this does not mean that all of these phenomena necessarily distort labor supply choices. This is particularly relevant to keep in mind when considering government policies. For example, pollution policies, if they were to effectively mimic the ideal pollution taxes favored by economists, would actually tend to bring input prices into line with social MVPs and would constitute no distortion at all. Treating the cost of pollution controls as fully distorting therefore probably overstates their effect, but by how much is far from clear. Thus, the aggregate non-tax wedge is probably overstated for the phenomena included in table 1. On the other hand, there are a large number of other phenomena which are not included in the table (because I could not find appropriate aggregate cost estimates). These include state and local regulations, rent controls, agricultural price supports, product liability costs, and so on. Including these would increase the estimated aggregate non-tax wedge. Thus, on balance, it is not clear whether the 15.7 percent figure overstates or understates the non-tax wedge. For that reason, I will use a range of values from 10 to 20 percent for the non-tax wedge in the illustrative calculations in the next section.
3. Tax and non-tax interactions This section uses the familiar partial equilibrium model of labor supply to investigate how tax and non-tax factors interact to determine three types of
424
E.K.
Browning,
The non-tax
wedge
Fig. 2
welfare costs, and to provide rough estimates of taking account of the non-tax wedge.
3.1.
of the quantitative
significance
The total welfare cost
In fig. 2, a representative worker’s social marginal value product is equal to w, the wage rate that would guide the labor supply decision in the absence of all tax and non-tax wedges. There is a non-tax wedge of n (expressed as a percentage of w), implying that the market wage rate would be w( 1 -n), or WI, even in the absence of taxes. However, now assume that there is also a tax on market earnings that applies at a murginal rate of m; this rate applies to market earnings net of the non-tax wedge, that is, labor supply valued at the marginal net wage rate confronting the worker is W’. Thus, w( 1 -n) (1 -m), or wi. The combined effect of the non-tax and tax wedges is to reduce the net wage below the MVP by (n+m-nm), expressed as a percentage of w. I will refer to (n +m-nm) as the total wedge, or T; note that it is less than the sum of the tax and non-tax wedges because the tax base is less than the MVP. The worker supplies L, hours of work at the net wage wi. Let S* be the compensated labor supply curve through the equilibrium point. Then the total welfare cost due to undersupply of labor is equal to the triangular area shown in fig. 2 as the sum of areas A and B. This welfare cost can be
E.K.
Browning,
The non-tax
expressed in a simple algebraic form labor supply curve is linear. Then the where dL is the compensated change familiar substitutions [see Browning expressed more conveniently as
wedge
425
if we assume that the compensated welfare cost is equal to (1/2)(dL)wT, in labor supply, Lo-L,. After some (1987)] the welfare cost, W, can be
where v is the compensated labor supply elasticity. Note that T replaces the marginal tax rate in this familiar formula since the welfare cost depends on the combined tax and non-tax wedge. Note also that eq. (1) evaluates labor earnings at the MVP, which is higher than the market wage by a factor of 1/(1-n). As mentioned earlier, estimates of this labor supply distortion have previously neglected the non-tax wedge. In terms of fig. 2, traditional estimates of the welfare cost of labor income taxation have produced estimates of area A by assuming that the market wage rate, w’, was equal to the MVP. This procedure understates the true welfare cost, which equals areas A+ B. The magnitude of understatement depends on the sizes of the tax and non-tax wedges and the compensated labor supply elasticity, as indicated in eq. (1). To put some perspective on the magnitude of understatement, I will use eq. (1) with aggregate U.S. data. Browning (1987) provides a discussion of the basis for selection of values for m and ‘1. Based on that discussion, I will use my preferred estimate of m of 43 percent4 For the compensated labor supply elasticity, interpreted as a weighted-average value, I will use a range of values (0.2, 0.3, and 0.4), since there is greater uncertainty about the appropriate value of this parameter. For the non-tax wedge it, the value suggested by the previous section is 0.15; I will also use values of 0.1 and 0.2 given the admitted imprecision of the estimate there. Finally, for aggregate labor earnings I use a value of $3,016 billion, based on figures for 1987.’ Note that this value for labor earnings corresponds to w’L, in fig. 2. To convert this figure to wL, as required by eq. (l), we multiply by l/(1 -n), a conversion factor that will vary with the value of n used. Based on these values, table 2 gives estimates of the total welfare cost in “This estimate is based on 1976 data, and is explained in Browning and Johnson (1984). Although there have been many changes in tax and transfer policies since 1976, I doubt that the weighted-average marginal tax rate has changed significantly. It is worth noting that the overall average tax rate (total tax revenues as a percent of GNP) has risen from 30.7 percent in 1976 to 32.0 percent in 1989. 5This is based on the Economic Report of the President (1989, Table B-24). which gives $2,683 billion as total compensation of employees. To this I have added adjustments for proprietors’ income and sales and excise taxes.
426
E.K. Browning,
The non-tax
wedge
Table 2 Total welfare cost (% billion).
\n 4 ~~~ 0.2 0.3 0.4
O \
~~~ 91.8 146.8 195.7
0.1 ~ 155.0 232.4 309.9
0.15
194.6 291.9 389.1
0.2
244.6 367.0 489.3
1987. For my preferred values of q (0.3) and n (0.15), the welfare cost is $291.9 billion, about 10 percent as large as total labor compensation6 Of greater interest is the importance of taking account of the non-tax wedge. Note that if the non-tax wedge is assumed to be zero (n=O), as implicitly assumed in all analyses of the welfare cost of taxation, the welfare cost estimated is only half its true value when n=0.15. Even if n is only equal to 0.1, the actual welfare cost is more than 50 percent larger than estimated by the conventional analysis. Previous estimates of labor supply distortions in the U.S. economy may therefore have significantly underestimated its true magnitude.
3.2. Marginal
werfhre cost of taxation
Although the total welfare cost of taxation alone is ambiguous when there are several tax and non-tax wedges, the marginal welfare cost of a specified change in the tax structure can be meaningfully estimated. Indeed, for the purpose of expenditure policy analysis it is the relevant measure of the welfare cost of taxation. Marginal welfare cost is the additional welfare cost due to the tax change per dollar of additional revenue generated, and it measures the amount that must be added to the direct cost of taxation (the revenue raised) to measure the social cost of funding the expenditure. (The term ‘marginal cost of funds’ is often used to mean the social cost of taxation per dollar of revenue; it equals one plus the marginal welfare cost.) Several estimates of the marginal welfare cost of taxation can be found in the literature [Stuart (1984), Wildasin (1984), Ballard et al. (1985) and Browning (1987)]. Fullerton (1991) has recently pointed out that several different definitions of marginal welfare cost (or marginal cost of funds) underlie these estimates. Most writers [for example, Ballard and Fullerton (1989) and Mayshar (1990, 1991)] argue that the most appropriate definition relies on the uncompensated change in labor supply induced by the tax rate change. I am in the minority in believing that the better definitions are the “Several caveats concerning cost are discussed in Browning
the accuracy (1987).
of this partial
equilibrium
estimate
of total
welfare
IX.
w1
Browning, The non-tax wedge
427
C
*2-
L2 Ll Fig. 3
ones that rely on the compensated change in labor supply, but all agree that there are cases when the compensated approach is appropriate. For example, when the expenditure policy being funded provides benefits to taxpayers that are a perfect substitute for the disposable incomes of taxpayers, use of the compensated labor supply curve to estimate marginal welfare cost is the correct approach [see Browning (1987)]. I will use the compensated approach here, but it should be emphasized that alternative approaches may be preferable for evaluating some types of expenditure policies. With that caveat in mind, consider fig. 3. The worker initially confronts a marginal tax rate of m and a net wage rate of wi, so labor supply is L,. Initially, I will assume that the tax is a proportional one so that the marginal and average rates are the same. Now the tax rate must be raised to m' to fund a specific expenditure policy. This reduces the net wage to w2 and labor supply declines to L, along the compensated labor supply curve. As a result, the welfare cost triangle increases by areas A+B, while tax revenue increases by areas C-B.’ The added welfare cost per dollar of revenue is thus (A + B)/(C - B); this is the marginal welfare cost. To suggest the quantitative significance of the non-tax wedge for the
‘1 am assuming that the non-tax wedge involves transfers to other people, just as the tax wedge involves transfers to government. Then when the tax rate increases, area A is a loss to those previously gaining, just as area B is a loss to the government.
428
E.K. Browning,
The non-tax wedge
marginal welfare cost of taxation, note that the additional is equal to wTdL, and dL equals qL, dm/( 1 -m). Thus, dW=
welfare cost, d W,
wT ‘I& dm.
(2)
ri
Additional revenue from the increase in the tax rate equals w’L, dm + w’mdL, which can be written as
welfare cost, M, is dW/dR,
Marginal
M=
lbT 1 _
‘?m
area
C-B,
or
or (after simplifying)
(4)
l-m This derivation’ is based on the assumption that the tax is proportional. ._ _ When the tax, or more precisely the tax change that generates the additional revenue, is non-proportional, the additional revenue is w’L, dt + w’m dL. The dt term is the change in the average tax rate which is now permitted to differ from the change in the marginal rate, dm. The added welfare cost is still determined exclusively by the change in the marginal tax rate, as in eq. (2). In this case, after some simplifications, marginal welfare cost is found to be
“0,
ME---!-T dt
(5)
In eq. (5), the dm/dt term measures the progressivity of the change in the tax structure that generates the added revenue. For a proportional change (even if the initial tax structure is progressive), dm/dt equals one, and eq. (5)
‘As mentioned previously, several economists prefer an approach in which uncompensated elasticities play the critical role. When this is the appropriate approach, eq. (4) can be used, but with q now interpreted as the uncompensated elasticity. [Eq. (4) can be derived from Mayshar’s (1991) eq. (3) by setting dm/dt equal to one and y equal to zero, but with m replacing 7’ in the numerator since Mayshar does not consider the non-tax wedge.] Two points are noteworthy. First, marginal welfare cost will be smaller when the uncompensated elasticity is used since it is less than the compensated elasticity. Second, marginal welfare cost will still be larger when a non-tax wedge is present (so T>m), just as is true in the compensated case.
429
E.K. Browning, The non-tax wedge Table 3 Marginal welfare cost of taxation (percentages). n
0
0.1
0.15
0.2
dm/dr\ 1.0 1.39 2.0
29.3 45.9 82.7
36.8 57.8 104.1
41.3 64.7 116.6
46.3 72.6 130.8
becomes eq. (4). Marginal welfare cost is larger the more progressive is the change in the tax structure, i.e. the larger is dm/dt. To use eq. (5) to estimate M, in addition to parameter values previously discussed we require dm/dt. I will use values of 1.0, 1.39, and 2.0 for dmfdt for reasons explained in Browning (1987). Table 3 shows how marginal welfare cost depends on dm/dt and the nontax wedge. (q equals 0.3 and m equals 0.43 for all the estimates in the table.) It is clear that ignoring the non-tax wedge (setting n=O) can lead to a substantial underestimate of the marginal welfare cost of taxation. With dm/dt equal to 1.39 and n =0.15, marginal welfare cost at 64.7 percent is 40 percent higher than the measure obtained on the assumption that only the tax system distorts labor supply decisions.g
3.3. Marginal
werfare cost of non-tax
distortions
The marginal welfare cost of a non-tax distortion can be defined as the additional welfare cost produced by a change in the non-tax wedge relative to the direct cost of the change in the non-tax wedge. Analogously to the case of taxation, this marginal welfare cost should be added to the direct cost of the non-tax wedge to arrive at the social cost of the non-tax phenomenon. It should be recalled, however, that I am examining only the distortion in the income-leisure decision here. Thus, the marginal welfare cost of monopoly, for example, as here considered, does not include the output mix distortion that is generally estimated. In general, the welfare cost of the output mix distortion would have to be combined with the marginal welfare cost derived here to obtain the relevant social cost measure. To evaluate a change in the non-tax wedge, assume that n increases to n’. In fig. 4, the direct effect of this is to reduce the market wage from w’ to w”. Since taxes apply to the market wage, the increase in n reduces the net wage ‘For purpose of comparison, suppose the uncompensated approach is relevant (as discussed in the previous footnote), and the uncompensated labor supply elasticity is 0.10. Then, from eq. (4), with a proportional tax, marginal welfare cost is 9.7 percent when n=O, and 13.8 percent, more than 40 percent higher, when n=0.15.
430
E.K. Browning,
The non-tax wedge
Fig. 4
from w’( 1 -m) to w”( 1 -m), i.e. from wi to w2, and labor supply falls from L, to L,.Area D is the direct cost of this change in the non-tax wedge, and areas A + B has been added to the welfare cost triangle. However, there is an additional cost in this instance because the government has lost tax revenue due to the lower wage rate and the lower quantity of labor. The reduction in tax revenue is given by D + B- C. The easiest way of taking account of this element of the cost is to assume that government increases tax rates so as to recover the lost revenue. Note, however, that increasing tax rates adds an additional element of welfare cost, the marginal welfare cost of taxation, as explained in the previous section. Thus, increasing the non-tax wedge directly adds B + A to the welfare cost, and indirectly adds M(D + B - C) as the social cost of the lost tax revenue. The marginal welfare cost of the non-tax wedge is therefore (A + B)/Dplus M(D+B-C)/D. Since A + B equals wTdL and D equals wL,dn, the first term simplifies to TV/( 1 -n). For the second term, B equals (w’-w,)dL and C equals (wz- w,)L,, so (D+ B--)/D simplifies to m(1 +r]). Therefore, the marginal welfare cost of the non-tax wedge, M,, equals: M.=z+M(rn[l
+n]).
In using eq. (6) to estimate the marginal welfare cost of the non-tax distortion, it should be kept in mind that the value of M depends on how
E.K.
Browning,
The non-tax
431
wedge
Table 4 Marginal \
\.
welfare cost of non-tax
n
dm/dt 1.0 1.39 2.0
0
0.1
29.3 38.6 59.1
36.8 48.5 14.4
distortion
(percentages).
0.15
0.2
\ 41.3 54.4 83.4
46.3 61.0 93.5
the tax system is changed to recoup the lost revenue and on other parameter values, as shown by eq. (5). With that in mind, table 4 gives estimates of M, for the parameter values used previously in table 3. Aside from the general implication in table 4 that the marginal welfare cost of non-tax distortions is quite substantial, two additional points should be made. First, note that the estimates in the first row of table 4 are the same as in the first row of table 3. This simply means that if the lost revenue is recouped with a proportional tax change, M, is the same as the marginal welfare cost of taxation for a proportional tax change (other parameter values the same, of course). This makes good intuitive sense since an increase in the non-tax wedge by itself has the same welfare implications as adding a proportional tax, so if the indirect effect from recouping lost revenue also uses a proportional tax, the total effect will be the same. The remainder of the estimates in table 4, however, are smaller than the corresponding figures in table 3. This is because they are in effect a weighted average of the marginal welfare costs of proportional and progressive (dm/dt greater than one) tax changes. Second, it should be recalled that M, compares the added welfare cost of the non-tax wedge with the direct cost of that wedge. For example, in the case of monopoly this means that the marginal welfare cost is a percentage of monopoly profits, not of the conventional welfare cost of monopoly. Using the value of M, based on dm/dt = 1.39 and n=0.15, along with the estimate of monopoly profits of 3 percent of NNP from table 1, the marginal welfare cost from the added labor supply distortion of monopoly is in excess of 1.5 percent of NNP (since M, is then greater than 50 percent). Since most estimates of the conventional welfare cost of monopoly based on the output mix distortion are well below 1 percent of NNP, this suggests that the marginal welfare cost due to labor supply effects may be quantitatively more important in evaluating the social cost of non-tax phenomena than the sort of distortions normally examined. 4. Conclusion The marginal
welfare
costs
of both
tax and
non-tax
policies
and institu-
E.K. Browning, The non-tax wedge
432
tions are likely to be significantly underestimated by ignoring the interaction between the distortions produced by both phenomena. A particularly important application is to the evaluation of government regulatory policies. While economists have long recognized that regulatory policies are an alternative to expenditure and tax policies, there has been little consideration given to the evaluation of the social costs of regulation on a comparable basis. In the case of expenditure policies, it is now well recognized that the marginal welfare cost of taxation is part of the social cost of the expenditure policy. lo This paper shows that there is an analogous marginal welfare cost for regulatory policies that plays the same role in policy analysis, and that this marginal welfare cost is likely to be significant when there are preexisting tax and non-tax wedges. Since governments are increasingly turning to regulatory measures as a way of averting an increase in the budget deficit, it is important to recognize that bypassing direct tax finance does not avoid the relevant social costs. “‘As a point of interest, this is now recognized also by the federal government. The Office of Management and Budget Circular No. A-94 (15 June 1992) notes on p. 14: ‘The presentation of results for public investments that are not justified on internal grounds should include an analysis with a 25 percent excess burden. Thus, in such analyses costs in the form of public expenditures should be multiplied by a factor of 1.25 and net present value recomputed.’ I thank a referee for providing this information.
References Ballard,
C.L. and D. Fullerton,
1989, Wage tax distortions
and public
good
provision,
Working
paper. Ballard, C.L., J.B. Shoven and J. Whalley, 1985, General equilibrium computations of the marginal welfare costs of taxes in the United States, American Economic Review 75, 128-138. Blinder, AS., 1987, Hard heads, soft hearts (Addison-Wesley, Reading, MA). Browning, E.K., 1985, The marginal social security tax on labor, Public Finance Quarterly 13, 227-251. Browning, E.K., 1987, On the marginal welfare cost of taxation, American Economic Review 77, 1l-23. Browning, E.K. and W.R. Johnson, 1984, The trade-off between equality and efficiency, Journal of Political Economy 92, 175-203. Burkhauser, R.V. and J.A. Turner, 1985, Is the social security payroll tax a tax?, Public Finance Quarterly 13, 253-267. Corlett, W.J. and D.C. Hague, 1953-1954, Complementarity and the excess burden of taxation, Review of Economic Studies 21, 21-30. Fullerton, D., 1991, Reconciling recent estimates of the marginal welfare cost of taxation, American Economic Review 81, 302-308. Harberger, A.L., 1962, The incidence of the corporation income tax, Journal of Political Economy 70,215240. Hirsch, B.T. and J.T. Addison, 1986, The economic analysis of unions (Allen and Unwin, Boston, MA). Hollinger, R.C. and J.P. Clark, 1983, Theft by employees (D.C. Heath, Lexington, MA). Hufbauer, G.C., D.T. Berliner and K.A. Elliott, 1986, Trade protection in the United States: 31 case studies (Institute for International Economics, Washington, DC). Mayshar, J., 1990, On measures of excess burden and their application, Journal of Public Economics 43.2633289.
E.K. Browning, The non-tax wedge
433
Mayshar, J., 1991, On measuring the marginal cost of funds analytically, American Economic Review 81, 1329-1335. McLure, C.E., Jr. and W.R. Thirsk, 1975, A simplified exposition of the Harberger model, 1: TdX incidence, National Tax Journal 28, l-28. Scherer, F.M., 1980, Industrial market structure and economic performance (Rand McNally, Chicago, IL). Stuart, C., 1984, Welfare costs per dollar of additional tax revenue in the United States, American Economic Review 74, 352-362. U.S. Council of Economic Advisers, 1985, Economic report of the President (U.S. Government Printing Oflice, Washington, DC). Weidenbaum, M.L., 1979, The future of business regulation (American Management Association, New York, NY). Wildasin, D.E., 1984, On public good provision with distortionary taxation, Economic Inquiry 22, 227-243.