When discussing taxation, the “tax wedge” refers to the amount of the gross income that is lost to taxes. It describes the difference between what someone earns and what they will bring home after paying taxes. The tax wedge quantifies the amount of taxes to be paid as a percentage of the gross income.

The concept of the tax wedge is linked to progressive taxation, a system in which the tax percentage increases as the taxable income increases. In such a system, individuals with higher incomes (taxable earnings) will pay more taxes. This creates a “wedge” between the gross income and the net income that a person can expect from their pay.

Tax wedges can lead to market inefficiencies. In a progressive tax system, the tax charged on some levels of income, such as a higher income, can be so high that it affects economic decision making. Individuals, households, and companies respond to the marginal incentives when making decisions. Therefore, the wedge in a progressive taxation schemes may act as a disincentive for some people; for example, when the taxation hits a certain level of earnings, some people may choose to work less due to the larger burden of taxation.

Furthermore, the market inefficiency caused by tax wedges can lead to dramatic changes in the prices of products and services, as well as artificial adjustments to the prices of wages, in an attempt to compensate for the wedge’s effect. For example, when companies are faced with a high tax wedge they may need to increase the prices of their goods in order to make up for the gap caused by the taxes.

Ultimately, while progressive taxation is necessary to fund government programs and services, it also creates an additional cost to society in the form of market inefficiencies. Although acknowledging the existent of tax wedges may not necessarily result in a decrease in tax burden, it is important for governments to understand their economic impact and to attempt at balancing the revenue needs with market incentives.