The Substantial Bias from Ignoring General Equilibrium Effects in Estimating Excess Burden, and a Practical Solution

This paper shows that under typical conditions the simple "excess-burden triangle" formula substantially underestimates the excess burden of commodity taxes. This formula performs poorly because it ignores general equilibrium interactions - most importantly, interactions between the market for the taxed commodity and the labor market. Using analytically tractable and numerically solved general equilibrium models, we show that the simple formula tends to significantly understate excess burden, in some cases by a factor of ten or more. We then derive an implementable alternative to the simple formula. This alternative formula captures interactions that are left out of the simple one, and as a result it is both unbiased and usually more accurate. Many prior theoretical studies have shown that general equilibrium interactions affect excess burden, but earlier work has not appreciated the bias associated with ignoring these interactions or recognized the quantitative importance of this bias. There are two main sources of our findings. The first is the recognition that the interaction between a new commodity tax and existing labor taxes will tend to be far more important than interactions with other taxes. Second, we focus on the case where the taxed commodity is average in terms of its substitutability with leisure. This greatly simplifies the analysis and allows us to derive an implementable alternative to the simple excess burden formula. One implication of this research is that government programs financed by taxes on particular intermediate or consumer goods must meet a higher benefit hurdle than is often assumed