Should deadweight loss die?

By Matt Nolan 19/08/2013


Over on VoxEu Charles Manski makes the case that deadweight loss is merely anti-tax rhetoric, and it should be thrown out of economic discourse!

I actually agree with what he is saying regarding analysis – that economists need to, where possible, look at tax and spending decisions simultaneously.  This implies that when we cost-benefit government projects, the implied cost of taxation needs to be explicitly taken into account.  I don’t think you’ll find anyone who disagrees.

But I don’t think DWL should go.  If we are going to go down the line of rhetoric – let’s make that communication to avoid unnecessary prerogative views – we can see the difference in his own summary of positions:

I depart from the Mirrlees setup in several ways.

  • First, I consider the use of tax revenue to finance public spending on infrastructure.
  • Second, I suppose that persons may have heterogeneous preferences for income, leisure, and public spending.
  • Third, the social planner may have partial knowledge of population preferences and of the productivity of infrastructure spending.

In contrast, the body of research on optimal income taxation stemming from Mirrlees (1971) has commonly studied the use of taxation to redistribute income while holding government spending fixed and has assumed that all persons have the same, known, preferences.

He is looking at a case where tax revenue is used to fund infrastructure spending and working out whether it is worthwhile.  The general discussion around deadweight loss with fixed government spending is a bit different as a communication device – is it to simply to show that there are distortionary impacts of taxation in the first place!  Often when communicating about government spending, it is much easier for people to see the “benefit” of the spending than the “cost”, especially the part of the cost that is due to allocative inefficiency.

Deadweight loss, and the countering principles of equity, give us a clear trade-off when it comes to redistribution.  However, we can extend this to thinking about the government funding government products and services and needing to pay workers with non-government produced goods and services.  This is the same jazz, but by adding in the additional complication of the direct benefit and cost of the government production we end up losing some clarity about the point regarding allocative efficiency.

I agree with him completely that we need to be careful we don’t get arbitrarily obsessed with the word “efficiency” and decide to use a heavy heuristic to fight against tax, instead of thinking about costs and benefits more directly.  However, deadweight loss is a term that is used to describe a very specific type of cost (allocative inefficency) which is due to government taxation (and even some government spending).  We are willing to accept this inefficiency due to the belief there is some other social value – namely equity considerations and public goods.  If used properly, this is a great method for helping to communicate taxation and spending goals to the public – goals we want the public to have input on given a clear association of the trade-offs they need to make a choice over!

Another point I’d like to make about this VoxEU piece is that it is determined to attack simplifying assumptions, and ones that have been loosened in the literature already (heterogeneous preferences, the type of utility function) – I dislike this style of argument, as it is trying to attack a way of thinking in a way that is not central to the argument at hand in order to be more compelling.  Someone who hasn’t read economic literature would get the impression that whenever someone talks about deadweight loss they are making piles of poor assumptions, and this is just untrue!

Note:  I’m also wondering if what he is intending is an extension of the Diamond-Mirrles 1971 series Iand II (pdf of Part 1).  I’ll have to see if I can find his paper and give it a read :)