Sunday, January 08, 2017

The Noise-to-signal Ratio as a Metaphor for the Deadweight Loss of Taxes

That is the name of an article of mine that was posted at the "Library of Economics and Liberty" site. Click here to read it. It is an elaboration and expansion on a letter to the editor of the WSJ I had published in 2007. Deadweight loss is a way for economists to show inefficiency of things like taxes and negative externalities. Deadweight loss increases at an increasing rate with taxes, similar to what I said in my letter.

Click here to go to my letter. Or you can read it here.
"Stephen Moore did a great job explaining how complicated our tax code is and how high taxes have gotten relative to what was originally promised in 1913. One other way to see the insidiousness of taxes is to realize that they are just as much the "noise" in the economy as prices are the "signals." The income you get paid is the price for your services and therefore signals the value of those services. But taxes reduce the clarity of that signal (hence, they are noise) by reducing how much of your pay you actually get to keep. As taxes increase, the noise-to-signal ratio in the economy increases even more, meaning distortions, and the misallocation of resources they cause increases disproportionately. For example, if the income tax rate is 10%, you keep 90% of your income. The noise-to-signal ratio is .111 (or .1/.9). But if the tax rate goes up by .10, or to 20%, the noise-to-signal ratio goes up even more, by .15 to .25 since you keep 80% of your income. The .25 comes from .20/.80 equaling .25. Another .10 increase in the tax rate increases the noise-to-signal ratio by .179 from .25 to .429. Then going from a 30% tax rate to a 40% tax rate makes it go up by .238, from .429 to .667. Every tax increase causes increasing damage to the economy's ability to efficiently allocate resources."

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