What Is a Tax Wedge?
Let me explain what a tax wedge is—it's the difference between your wages before taxes and after taxes. This measures how much the government effectively gets from taxing the workforce.
You might also hear tax wedge used to describe the market inefficiency that pops up when a tax gets slapped on a good or service. That tax shifts the supply and demand balance, leading to what's called deadweight losses.
Key Takeaways
The tax wedge boils down to the net difference between your gross income and what you actually take home after taxes are deducted. In progressive tax systems, this wedge gets bigger marginally as your income goes up. Economists point out that it creates market inefficiencies by messing with the real price of labor, goods, and services.
Understanding the Tax Wedge
If you're an employee, you know taxes get withheld from your paycheck, so what you take home is less than your gross pay or the full cost to your employer. The tax wedge is that gap—between what you earn net and the total labor cost, or basically the income tax rate in dollars.
The OECD defines it as the ratio of taxes paid by an average single worker—someone earning 100% of average wages, no kids—to the employer's total labor cost. Some folks argue that a tax wedge on investment income cuts into savings and drags down living standards over time.
When net income drops, you might decide to work less or chase ways to hold onto more money, like tapping government benefits. That can shrink the workforce, with remaining employees pushing for higher pay, which makes employers hire less.
Example of the Tax Wedge
In some places, the tax wedge grows as your income rises, cutting the incentive to work extra hours—you'd do more if there were no taxes. So, we calculate the wedge to see how higher payroll taxes hit hiring.
Take an employee with $75,000 gross income in 15% federal and 5% state tax brackets. Net income is $75,000 times 0.80, which is $60,000. In a progressive setup, taxes might jump to 25% federal and 8% state, withholding $24,750, leaving net at $50,250—or $75,000 times 0.67.
Tax Wedge and Market Inefficiency
You can also use the tax wedge to figure the percentage of market inefficiency from sales taxes. Taxing a good or service shifts the equilibrium price and quantity, and that deviation is the wedge.
This inefficiency means consumers pay more and producers get less than before the tax, thanks to higher prices and lower quantities sold. Essentially, the sales tax wedges between what buyers pay and what sellers receive.
What Does the Tax Wedge Measure?
It measures how much the government gets from taxing the labor force.
What Is a More Technical Definition of a Tax Wedge?
Per the OECD, it's the ratio of taxes paid by an average single worker at 100% average earnings, no children, to the employer's total labor cost.
Arguments Against the Tax Wedge
- Economists say it creates market inefficiencies by shifting the true price of labor, goods, and services.
- Some argue it reduces savings from investment income, lowering living standards.
- Lower net income might make employees work less or seek benefits to retain more earnings.
The Bottom Line
To wrap it up, the tax wedge is the net difference between gross and net income after taxes. It shows government revenue from labor taxes, and in progressive systems, it increases marginally with income.
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