Tax Wedge

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Tax Wedge

What Is a Tax Wedge?

The difference between before-tax and after-tax earnings is referred to as a tax wedge. The tax wedge calculates how much the government theoretically obtains through worker taxes.

Tax wedge may also refer to the market inefficiency caused by imposing a tax on an item or service. The tax shifts the supply and demand balance, resulting in a wedge of dead weight losses.

Key Takeaways

  • The tax wedge is the difference between gross and net income after taxes are subtracted.
  • The tax wedge grows on a marginal basis as income grows under progressive tax regimes.
  • According to economists, a tax wedge generates market inefficiencies by artificially altering the real price of labor, products, and services.

Understanding the Tax Wedge

Many workers have taxes deducted from their paychecks, resulting in take-home pay that is less than the gross compensation or wage or the cost of employing them. The tax wedge, or the dollar measure of the income tax rate, is the difference between what workers take home in wages and what it costs to employ them (labor cost). A tax wedge is defined by the Organization for Economic Cooperation and Development (OECD) as the ratio between the amount of taxes paid by an average single worker (a single individual earning 100% of the average wage) without children and the comparable total labor cost for the employer. Some claim that the tax on investment income will discourage savings and, as a result, degrade living standards.

Employees may decide to labor less or find other methods to retain more of their earnings if their net income falls (by using government benefits, for example).While applications for government benefits increase, the workforce suffers as those who remain want greater pay, prompting firms to reduce their recruiting rate.

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Example of the Tax Wedge

In certain nations, the tax wedge widens as employee earnings rise. Because the marginal benefit of working is reduced, workers often work less hours than they would if no tax was imposed. As a result, a tax wedge might be constructed to assess how increasing payroll taxes effect hiring in the long run.

Assume an employee’s gross income is $75,000 and he falls into the 15% and 5% federal and state income tax rates, respectively. His net income will be $75,000 multiplied by 0.80 = $60,000. In a progressive tax system, income taxes are gradually raised to 25% and 8% at the federal and state levels, respectively. The amount of tax deducted from gross income is now $24,750, and net income is $75,000 – $24,750 (or $75,000 multiplied by 0.67) = $50,250.

Tax Wedge and Market Inefficiency

A tax wedge may also be used to determine the degree of market inefficiency caused by sales taxes. The equilibrium price and quantity change when an item or service is taxed. The tax wedge is the resultant price or quantity that deviates from the equilibrium. Due to higher equilibrium prices paid by consumers and lower equilibrium quantities supplied by producers, market inefficiency caused by a tax wedge would force the consumer to pay more and the producer to get less for the item than they did before the tax. In effect, the sales tax creates a “wedge” between the price paid by consumers and the price paid by manufacturers for a product.

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