MIT's Hendren's Basic Error in Cost/Benefit Analysis Regarding Medicaid

Don't Forget Deadweight Loss, aka, Excess Burden

By David R Henderson. Excerpt:

"He ignores the deadweight loss from taxation, also known as the excess burden of taxation.

Economists who study taxation understand that virtually every existing tax imposes a deadweight loss. This is a loss to society beyond the taxes collected. It arises because every tax distorts behavior. A tax on imports reduces imports, thus reducing gains from trade for the frustrated exporter and the frustrated importer (with most of the deadweight loss typically being borne by the importer.) A tax on income reduces the incentive to work and invest. A corporate income tax strongly reduces the incentive to invest.

Economists have estimated ranges of deadweight loss (DWL) per dollar of revenue raised and they find that those are often substantial.

Here’s what Harvey S. Rosen and Ted Gayer write in the 9^th edition of their excellent textbook Public Finance:

Because excess burden increases with the square of the tax rate, the marginal excess burden from raising one more dollar of revenue exceeds the average excess burden. That is, the incremental excess burden of raising one more dollar of revenue exceeds the ratio of total excess burden to total [government] revenues. This fact has important implications for cost-benefit analysis. Suppose, for example, that the average excess burden per dollar of tax revenue is 12 cents, but the marginal excess burden per additional dollar of tax revenue is 27 cents [Jorgenson and Yun, 2001, p. 302]. The social cost of each dollar raised for a given public project is the dollar plus the incremental excess burden of 27 cents. Thus, a public project must produce marginal benefits of more than $1.27 per dollar of explicit cost if it is to improve welfare.

The term “explicit cost” in the last sentence is ambiguous, though fairly clear in this context. But it would have been even clearer to substitute “government spending” for “explicit cost.”

With that in mind, let’s go back to Hendren’s 50 cents to $1.20 estimate of the benefits. Even if the right number is at the high end, $1.20, most incremental taxes impose more than 20 cents of DWL per dollar of government revenue. So the Oregon Medicaid spending flunks a cost/benefit test."