OK you guys are getting too hung up on it being gasoline in the previous post. Let me start over. Now in the following, I’m not necessarily saying each arguments in any of the steps is correct. I’m just saying, you could easily see an economist going along with the chain of logic, and yet (as we’ll see) we wind up with a contradiction. So the point of this exercise is to pinpoint where the mistake comes in.
(0) Initially the government raises $1 trillion by levying a percentage tax on labor income. There are 100 consumer goods in the economy that initially have equal sales (by revenue).
(1) The government enacts a percentage tax on Consumer Good #1, and reduces the percentage tax on labor income, so that when the dust settles the Treasury takes in $10 billion from the tax on Good #1, and $990 billion from the (now lower) tax on labor. I.e. it was a revenue-neutral tax swap of $10 billion.
Many economists would probably go along with the claim that this move would increase the deadweight loss to the economy from the tax code. Clearly if the government did a complete tax swap–i.e. raised the entire trillion dollars by taxing the heck out of Consumer Good #1 while not taxing anything else–that would be very destructive compared to the status quo. (The intuition is that the tax base on Consumer Good #1 is much smaller than all of labor, so the percentage rate would have to be much higher on Good #1 than for labor.) So if doing a full tax-swap would be awful, then presumably a 1-percent tax swap would be bad too, just not as bad.
(2) Now if you buy the argument in step (1), then the case is even stronger that doing another $10 billion tax swap–this time for Consumer Good #2–would add to the deadweight loss. This is because the starting labor tax percentage here is lower than it was in step (1), since at this point the tax on labor only needs to bring in $990 billion. So on the margin, the benefit of cutting taxes on labor by $10 billion is lower than it was originally, while the harm of imposing new taxes of $10 billion on a consumer good is at least as high as it was before.
(3) If you bought the logic in Step (2), then it clearly applies for further $10 billion tax swaps for Consumer Goods #3…#100. Each $10 billion tax swap ought to impose incrementally higher deadweight losses on society from the new tax code.
==> However, what if we initially implemented a revenue-neutral flat consumer tax swap deal, to raise $1 trillion from a uniform levy on consumer goods, while eliminating the tax on labor altogether? This is the ideal of standard tax policy reform analysis. In a simplified model where there is no leisure or other forms of income, at worst this move would be a wash. But in a more realistic model, this implementation of a consumption rather than a labor tax would be a net positive.
==> So what the heck is going on here? If we do the sequential tax swap deals, one consumer good at a time, we end up with raising all of the government’s revenue from taxing the consumer goods while phasing out the labor tax, and yet we seemed to show that this would be awful. Yet we have a standard result that putting in a revenue-neutral consumption tax and eliminating labor taxes is great.
(Just to reiterate, I am deliberately feigning ignorance above, because I see at least some of the flaws in the breezy presentation. But it took me a minute to get my bearings, and it’s possible I’m still overlooking some subtleties.)