A causal-realist analysis of deadweight loss from taxation

Abstract

The standard microeconomic analysis of taxation suggests that excise taxes on goods with a
price-inelastic demand are more efficient in that they lead to a lower deadweight loss. This
argument ignores secondary effects on the rest of the economy. By narrowly focusing on the
primary effects on the market where the tax is raised, the overall deadweight loss is
underestimated when demand is price-inelastic. Moreover, it is overestimated when demand
is price-elastic. This puts into question the validity of the standard argument. In this paper we
address this issue from the point of view of causal-realist price theory. Following this
approach we can clearly see how the impact of an excise tax is not limited to one market in
isolation, but is spread over all markets and affects the demand for cash balances.

Keywords: tax, deadweight loss, price elasticity

JEL Classification: D60, H21