Policy Documents

Tax Efficiency: Not All Taxes Are Created Equal

Jason Clements, Niels Veldhuis, and Milagros Palacios –
January 1, 2007

One reason that governments impose taxes is to finance the services that citizens demand. This study examines how governments can extract tax revenues in the least costly and economically damaging manner in order to improve economic performance.

Costs of taxation

Efficiency costs

The costs associated with taxation extend far beyond
the amount of tax collected. First, there are significant
incentive-based costs, which are generally referred to as
efficiency costs. These costs emerge because taxes alter
relative prices and thus the incentives for productive
behaviour and affect a wide range of decisions regarding
savings, investment, effort, and entrepreneurship.
These costs vary widely by the type of tax.

One main method for quantifying these costs is
referred to as the marginal efficiency cost (MEC). It
calculates the cost of raising one additional dollar of
tax revenue using different types of taxes. Estimates of
the marginal efficiency costs of both American and
Canadian taxes indicate that consumption and payroll
(wage and salary) taxes are much less costly (and thus
more efficient) than taxes on capital or the return to
capital. For example, a study by the Department of
Finance for the OECD (1997) concluded that corporate
income taxes imposed a marginal cost of $1.55
(MEC) for one additional dollar of revenue compared
to $0.17 for an additional dollar of revenue raised
through consumption taxes.