Tax Wedge Definition
A tax wedge can be defined as an underlying difference between pre-tax (gross income) and post-tax (after-tax income) wages and it is used for the purpose of understanding the financial implications of a tax burden that is imposed on a particular product or service and this is the reason why it yields income for the governments but at the same time leverages the level of inefficiencies in a financial market.
Tax Wedge can be learned as an existing difference or gap between demand and supply price. This difference between the demand and supply curveSupply CurveSupply curve represents the relationship between quantity and price of a product which the supplier is willing to supply at a given point of time. It is an upward sloping curve where the price of the product is represented along the y-axis and quantity on the x-axis. is created as a result of the tax being imposed on a financial marketFinancial MarketThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.. Levying taxes on a financial market can result in inefficiencies and create a gap between the demand and supply price. It takes place because the demand price is borne by the customers already comprises of the taxes, whereas the supply price received by the suppliers doesn’t comprise of these taxes. As a result of the standard demand and supply curve, i.e., the negative and positive slope, the tax implications are levied upon both the customers and the suppliers.
Formula to Calculate Tax Wedge
The calculation formula is as follows:
- Before-tax wedges refer to the wages which the employee has earned before any deduction in the form of the taxes from it.
- After-tax wages refer to wages which the employee has earned after deducting the taxes as applicable to him.
The other formula used for the calculation of tax wedge on labor is as follows:
- Average Total Labor Costs = Employee Wage Earnings + Employer Social Insurance and Payroll Taxes
- Net Take – Home pay = Employee Wage Earnings – Income and Social Insurance Taxes + Cash Transfers
How to Calculate the Tax Wedge?
Following are the steps that can be used to calculate for an employee earning the wages:
- Calculate the Before-Tax Wages
Firstly, calculate the before-tax wages which are earned by the employee during the period of time under consideration.
- Identify the Slab of the Tax Rate
After that, identify the slab of the tax rate, which is applicable to the employee as per the federal as well as the state tax bracket of income, i.e., identify the rate of taxation applicable to the employee.
- Calculate the tax
Calculate the tax that the employee is required to pay to the state and federal government by multiplying the tax rate with the gross wagesThe Gross WagesGross wages are the amount of remuneration paid to employees before any deductions like taxes, including social security and Medicare, life insurance, pension contributions, bonuses.. The tax to be paid is the tax wedge, which measures the amount received by the government from taxing its labor force.
- Determine the after-tax wages
Determine the after-tax wages of the person by deducting the tax calculated in step 3 from the gross incomeGross IncomeThe difference between revenue and cost of goods sold is gross income, which is a profit margin made by a corporation from its operating activities. It is the amount of money an entity makes before paying non-operating expenses like interest, rent, and electricity..
- Calculate the tax wedge
Calculate the tax wedge by deducting the after-tax wages as calculated in step 4 from the before-tax wages as determined in step 1.
For example, Bill earned $200,000 as a salary in the year 2018. He is entitled to pay a 20 % federal tax and 10 % state and local tax on his salary earned in the year 2018. This means that he paid $40,000 ($200,000 * 20 %) as federal taxes and $20,000 ($200,000 * 10 %) as state and local taxes. Therefore, Bill is left with a remaining salary of $140,000 ($200,000 – $40,000 – $20,000) after the payment of both federal and state and local taxes. If there is a rise in federal tax rate and state and local tax rate from 20 % to 30 % and 10 % to 15 % respectively, then Bill will be left with $110,000 only.
- ($200,000 * 30 %) = $60,000 (federal taxes)
- ($200,000 * 15 %) = $30,000 (state and local taxes)
- Salary after taxes = $90,000 ($200,000 – $60,000 – $30,000)
During this sudden hike in taxes, Bill and other employees might not find it convenient to work as an employee and they might start looking for better modes of earning their bread and butter.
The importance is enumerated and discussed as follows-
- It is highly useful in the calculation of the percentage of inefficiencies caused in the market as a result of the sales taxSales TaxThe government levies sales tax on the consumption of various goods and services as the percentage added to the product and services from which the government earns revenue and does the company's welfare. In the United States, 38 different states have different taxes, from Alaska (1.76%) to Tennessee (9.45%)..
- It can be used as a measure of evaluating the total tax burden on both labor and employment for any country.
- It enables in the better assessment of the economic impact of employee social insurance contributions as well as employer social insurance contributions that are often neglected in the wider tax segment.
- It helps in generating income for the governments while leveraging inefficiencies in the financial market.
- The greater the rate of tax wedge, the higher is the possibility for the same to be present in an informal sector instead of the formal sector.
- In an informal setup, a change in tax wedge might have a minimal impact on the overall employment while having a larger impact on wages.
The tax wedge is merely a difference that remains between gross income and net income once the taxes are deducted. In a progressive taxProgressive TaxProgressive tax refers to the increase in the average rate of tax with the increase in the amount of taxable income so that the liability of paying heavy taxes passes to those who earn a higher income and those with lower income can have a relaxation from the heavy income tax obligations. mechanism, It might increase on a marginal basis with the rise in income. It might also be taken into use for the purpose of calculating the overall percentage of market inefficiencies that are introduced as a result of sales taxes. The inefficiencies caused in the financial market as a result of tax wedge might enable the customer to pay slightly more and the supplier or the manufacturer to receive a lower amount for the goods or services in comparison to the amount that they were usually paying/receiving before the implications of taxes as a result of greater equilibrium prices that are paid by the customers and lower number of equilibrium quantities that are sold by the suppliers or manufacturers.
This article has been a guide to the tax wedge and its definition. Here we discuss formula and example to calculate tax wedge along with its importance. You can learn more about financing from the following articles –