Taxes are generally distortionary.  That is the cost to individuals in our economy of collecting a dollar of tax revenue exceeds the tax revenue that is collected because people change their behavior in response to price changes that are caused by the tax.  The marginal excess burden of raising a dollar of tax revenue is the technical term for how much extra pain is imposed on people in order to collect another dollar of tax revenue.  Economic damage is a helpful, non-technical term I often used to explain the marginal excess burden of a dollar of tax revenue to non-economists.

According to the federal Office of Management and Budget (OMB) during the Bush, Clinton, Bush, and Obama administrations, “Recent studies of the U.S. tax system suggest a range of values for the marginal excess burden, of which a reasonable estimate is 25 cents per dollar of revenue.” (Item 11)

This means that the total cost of collecting a marginal dollar of additional tax revenue from slightly higher tax rates is $1.25.  This includes both the dollar that is collected from people in the private sector economy and the economic damage from the distortions caused by the tax.  The dollar of tax revenue is a transfer from the private sector taxpayers to the government.  The extra quarter of excess burden is the cost of distorting decision-making. It is a waste to society.  Instead of making decisions only for common sense reasons some decisions are changed when relative prices are changed by the tax.  This behavioral response makes our economy less efficient.  The benefits of public expenditures financed by taxation should be weighed against the marginal costs of raising taxes.

According to the Office of Management and Budget, “Where specific information clearly suggests that the excess burden is lower (or higher) than 25 percent, analyses may use a different figure. When a different figure is used, an explanation should be provided for it. An example of such an exception is an investment funded by user charges that function like market prices; in this case, the excess burden would be zero. Another example would be a project that provides both cost savings to the Federal Government and external social benefits.”

Alternatively, if the marginal tax rate is especially high, then both the excess burden and the marginal cost of public funds may be larger because generally the distortions created by taxation increase quadratically with the tax rate.