Donald Marron of the Tax Policy Center has written a wonderful short post explaining the excess burden of taxation:
Suppose there are five people who might buy a pizza. The first person values a pizza at $14.50, the second at $13.50, the third at $12.50, the fourth at $11.50, and the fifth at $10.50.
If pizzas cost $10, all five people will buy one. The first person gets a net benefit of $4.50, since the pizza was worth $14.50 to her, but she paid only $10. The second person gets a benefit of $3.50, and so on. Add it all up, and the benefit of the pizza market is $12.50 (= $4.50 + $3.50 + $2.50 + $1.50 + $0.50).
Now suppose that the government levies a 10% tax on pizzas; that lifts the price to $11. Now only the four consumers who place the highest value on pizzas will buy them; Mr. $10.50 won’t buy. The four remaining consumers now benefit by $3.50 + $2.50 + $1.50 + $0.50 = $8.00 from buying pizza. The government collects $4.00 in revenue, so the total economic benefit of the pizza market is $12.00, $0.50 less than before. That 50-cent loss falls on the hungry guy who no longer buys a pizza. The $1 loss for each of the four buyers isn’t lost to the economy; instead, it transfers to the government.
Now suppose, instead, that the tax is 20%; pizzas now cost $12 each, and only three consumers will buy. Their total benefit is $4.50 (= $2.50 + $1.50 + $0.50). The government collects $6.00 in revenue, so the total economic benefit is $10.50. That’s $2.00 less than without a tax.
So there you have it. When you double the tax from 10% to 20%, you quadruple the economic harm from $0.50 to $2.00.
When targeted tax incentives force us to increase tax rates to raise the same amount of revenue, we damage the economy far more than we would if we used direct expenditures to achieve the same goals.