Tax Wedge

A tax wedge is the difference between before‑tax and after‑tax earnings. It captures how much of labor compensation is taken by taxes (and payroll contributions), and it also describes the gap created between buyer and seller prices when a tax is imposed on a good or service.

How the tax wedge is measured

• For labor: the tax wedge is commonly expressed as the ratio of total taxes paid by a representative worker (including income taxes and social contributions) to the total labor cost to the employer (wages plus employer payroll taxes). The Organisation for Economic Co‑operation and Development (OECD) uses a similar definition for cross‑country comparisons.
• For goods and services: the wedge is the difference between the price consumers pay and the price producers receive after a tax is applied.

Why it matters

• Labor supply: a larger tax wedge reduces the net benefit of working, which can discourage labor participation or hours worked.
• Hiring costs: higher employer labor costs (even if some are paid by workers via reduced take‑home pay) can reduce firms’ willingness to hire.
• Savings and investment: taxes on investment income can shrink returns, potentially lowering saving and long‑term living standards.
• Market efficiency: taxes create a distortion between consumer price and producer receipts, often producing deadweight loss by reducing traded quantity below the untaxed equilibrium.

Example

Consider an employee with gross income of $75,000.

• Scenario A (lower tax rates): federal 15% + state 5% = 20% total tax
  Net income = $75,000 × (1 − 0.20) = $60,000

• Scenario B (higher marginal tax rates): federal 25% + state 8% = 33% total tax
  Tax withheld = $75,000 × 0.33 = $24,750
  Net income = $75,000 − $24,750 = $50,250

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As marginal rates rise, the tax wedge grows and the worker’s take‑home pay falls, reducing the marginal reward for additional work.

Tax wedge and market inefficiency

When a sales tax or similar levy is added:

• Consumers face a higher price.
• Producers receive a lower effective price.
• The quantity traded falls below the untaxed market equilibrium.
• The difference between the price paid by consumers and the price received by producers is the tax wedge; the reduction in total surplus that is not transferred to the government is deadweight loss.

Common criticisms and economic effects

• Distortion: taxes distort price signals, leading to less efficient allocation of labor and resources.
• Labor supply responses: higher wedges can reduce hours worked or push workers toward tax‑favored activities and benefits.
• Reduced savings: taxes on investment income can discourage saving, potentially lowering capital accumulation and growth.
• Distributional tradeoffs: lowering tax wedges for some groups may require higher taxes elsewhere or reduced public services.

Key takeaways

• The tax wedge measures the gap between gross and net wages or between consumer and producer prices after taxation.
• Larger tax wedges can discourage work, hiring, and saving, and introduce deadweight losses in markets.
• Policymakers weigh efficiency costs against revenue needs and distributional goals when setting tax levels and structure.