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The Usual Excess-Burden Approximation Usually Doesn't Come Close

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  • Lawrence H. Goulder
  • Roberton C. Williams III

Abstract

This paper shows that the usual excess-burden triangle' formula performs poorly when used to assess the excess burden from taxes on intermediate inputs or consumer goods, and derives a practical alternative to this formula. We use an analytically tractable general equilibrium model to reveal how interactions with pre-existing taxes in other markets critically affect the excess burden of new taxes on intermediate inputs or consumer goods. The usual excess-burden formula ignores these interactions, and consequently yields highly inaccurate assessments of excess burden. Prior economic theory implicitly acknowledges the relevance of general-equilibrium interactions to excess burden, but does not indicate which interactions are most important or reveal the fundamental (first-order) contribution of these interactions. Moreover, prior studies do not offer a practical alternative to the usual excess-burden approximation. This paper helps fill the gap between theory and practice. First, it shows analytically that the importance of the interaction with a given pre-existing tax is roughly proportional to the amount of revenue raised by that tax. Second, the paper derives a practical alternative formula for approximating the excess burden from a commodity tax. Finally, it performs numerical simulations to illustrate the significance of adopting our alternative to the usual approximation formula. For realistic parameter values and a wide range of assumed rates for prior taxes, the usual formula captures less than half of the excess burden of taxes on commodities. When the rate of the new tax is small,' this formula captures less than five percent of the true excess burden. In contrast, the alternative approximation formula derived here yields estimates that are consistently within five percent of the actual excess burden.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7034.

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Date of creation: Mar 1999
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Publication status: published as Goulder, Lawrence and Roberton C. Williams III. "The Substantial Bias from Ignoring General Equilibrium Effects in Estimating Excess Burden, and a Practical Solution." Journal of Political Economy 111 (2003): 898-927.
Handle: RePEc:nbr:nberwo:7034

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  1. Robin Boadway & Richard Harris, 1975. "A Characterization of Piecemeal Second Best Policy," Working Papers, Queen's University, Department of Economics 195, Queen's University, Department of Economics.
  2. Ruud de Mooij & A. Bovenberg, 1998. "Environmental Taxes, International Capital Mobility and Inefficient Tax Systems: Tax Burden vs. Tax Shifting," International Tax and Public Finance, Springer, vol. 5(1), pages 7-39, February.
  3. Williams III, Roberton C., 1999. "Revisiting the cost of protectionism:: The role of tax distortions in the labor market," Journal of International Economics, Elsevier, vol. 47(2), pages 429-447, April.
  4. Bovenberg, A.L. & Mooij, R.A. de, 1994. "Environmental levies and distortionary taxation," Open Access publications from Tilburg University urn:nbn:nl:ui:12-152985, Tilburg University.
  5. Lucas, Robert E, Jr, 1990. "Supply-Side Economics: An Analytical Review," Oxford Economic Papers, Oxford University Press, vol. 42(2), pages 293-316, April.
  6. Lars Hokonsen, 1998. "An Investigation into Alternative Representations of the Marginal Cost of Public Funds," International Tax and Public Finance, Springer, vol. 5(3), pages 329-343, July.
  7. Browning, Edgar K, 1987. "On the Marginal Welfare Cost of Taxation," American Economic Review, American Economic Association, vol. 77(1), pages 11-23, March.
  8. Bovenberg, A Lans & van der Ploeg, Frederick, 1992. "Environmental Policy, Public Finance and the Labour Market in a Second-best World," CEPR Discussion Papers 745, C.E.P.R. Discussion Papers.
  9. Ballard, Charles L & Shoven, John B & Whalley, John, 1985. "General Equilibrium Computations of the Marginal Welfare Costs of Taxes in the United States," American Economic Review, American Economic Association, vol. 75(1), pages 128-38, March.
  10. Parry, Ian W. H. & Williams, Roberton III & Goulder, Lawrence H., 1999. "When Can Carbon Abatement Policies Increase Welfare? The Fundamental Role of Distorted Factor Markets," Journal of Environmental Economics and Management, Elsevier, vol. 37(1), pages 52-84, January.
  11. Bovenberg, A Lans & de Mooij, Ruud A, 1997. "Environmental Levies and Distortionary Taxation: Reply," American Economic Review, American Economic Association, vol. 87(1), pages 252-53, March.
  12. Charles L. Ballard & Don Fullerton, 1993. "Distortionary Taxes and the Provision of Public Goods," NBER Working Papers 3506, National Bureau of Economic Research, Inc.
  13. Auerbach, Alan J., 1985. "The theory of excess burden and optimal taxation," Handbook of Public Economics, Elsevier, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 1, chapter 2, pages 61-127 Elsevier.
  14. Atkinson, A. B. & Stiglitz, J. E., 1972. "The structure of indirect taxation and economic efficiency," Journal of Public Economics, Elsevier, vol. 1(1), pages 97-119, April.
  15. Lawrence H. Goulder & Ian W. H. Parry & Dallas Burtraw, 1996. "Revenue-Raising vs. Other Approaches to Environmental Protection: The Critical Significance of Pre-Existing Tax Distortions," NBER Working Papers 5641, National Bureau of Economic Research, Inc.
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Cited by:
  1. Gilbert E. Metcalf, 2000. "Environmental Levies and Distortionary Taxation: Pigou, Taxation, and Pollution," Discussion Papers Series, Department of Economics, Tufts University, Department of Economics, Tufts University 0004, Department of Economics, Tufts University.
  2. Don Fullerton & Inkee Hong & Gilbert E. Metcalf, 2001. "A Tax on Output of the Polluting Industry Is Not a Tax on Pollution: The Importance of Hitting the Target," NBER Chapters, in: Behavioral and Distributional Effects of Environmental Policy, pages 13-44 National Bureau of Economic Research, Inc.
  3. Lee, Fitzroy A., 2002. "Telecommunications Tax Design: The Role of A Preexisting Labor Tax Distortion," National Tax Journal, National Tax Association, vol. 55(N. 1), pages 41-56, March.
  4. Parry, Ian, 2000. "Comparing the Marginal Excess Burden of Labor, Gasoline, Cigarette and Alcohol Taxes: An Application to the United Kingdom," Discussion Papers, Resources For the Future dp-00-33-rev, Resources For the Future.

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