What Does ‘Economic Distortion’ Look Like?

December 18, 2006

Economists often criticize special tax exemptions, credits and deductions because they make people do things for tax reasons that otherwise make no economic sense—something economists call “economic distortion.”

But economic distortion is an abstract concept. It’s hard to illustrate to journalists and others how millions of tiny tax-induced distortions in the economy can total up to a huge economic loss for the nation as a whole, reducing everyone’s well-being simply because lawmakers have written poor tax policy into law that encourages people to waste resources on minimizing tax burdens rather than engage in productive activity like work and saving.

Thankfully, today’s Wall Street Journal provides ample illustration of the economic waste induced by taxpayers’ year-end scramble to take advantage of the vast array of special preferences in the current federal tax code:

There’s still time to cut your taxes — and this year there are a few new tricks.

Congress has just restored several tax breaks that expired at the end of last year. The most notable: a provision giving millions of people the option of deducting their state and local sales taxes instead of their state and local income taxes. That’s particularly good news for taxpayers in states with no income tax, such as Florida, Texas and Washington. President Bush is expected to sign the legislation into law sometime in the next few days.

Even if you don’t benefit from the restored tax breaks — they also include a special deduction for higher-education tuition and fees — it’s not too late to take a few steps to trim your 2006 bill. (Read the full piece here.)

The article goes on to recommend a wide range of costly activities taxpayers should engage in to minimize tax burdens: selling off capital losses, giving to charity, giving money to your spouse, timing the realization of income from work, and so on.

Of course, all of these make sense as financial moves for individual taxpayers. But from the perspective of the economy as a whole, they represent actions that are driven by distortionary tax policy rather than sound economic reasoning. All that effort spent trying to minimize tax burdens undoubtedly represents real economic waste—waste that Members of Congress inadvertently encourage through the proliferation of distortionary credits, deductions and exemptions throughout the tax code.

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