A distortion is departure from the allocation of economic resources from the state in which each agent maximizes his/her own welfare. A proportional wage-income tax, for instance, is distortionary, whereas a lump-sum tax is not. In a competitive equilibrium, a proportional wage income tax discourages work.
In perfect competition with no externalities, there is zero distortion at market equilibrium of supply and demand where price equals marginal cost for each firm and product. More generally, a measure of distortion is the deviation between the market price of a good and its marginal social cost, that is, the difference between the marginal rate of substitution in consumption and the marginal rate of transformation in production. Such a deviation may result from government regulation, monopoly tariffs and import quotas, which in theory may give rise to rent seeking. Other sources of distortions are uncorrected externalities, different tax rates on goods or income, inflation, and incomplete information. Each of these may lead to a net loss in social surplus.
See also 
- Alan Deardorff. "Distortion", Deardorff's Glossary of International Economics.
- Stephen D. Williamson (2010). "Sources of Social Inefficiencies," Macroeconomics, 3rd Edition.
- Agnar Sandmo (2008). "Pigouvian taxes." The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
- •Louis Kaplow (2008). "optimal taxation," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
• Louis Kaplow (2008). "income taxation and optimal policies," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
• Alan J. Auerbach (2008). "taxation of corporate profits," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
- S. Rao Aiyagari, R. Anton Braun, Zvi Eckstein (1998). "Transaction Services, Inflation, and Welfare," Journal of Political Economy, 106(6), pp. 1274-1301 (press +).
- • T. N. Srinivasan (1987). "distortions," The New Palgrave: A Dictionary of Economics, v. 1, pp. 865-67.
• Joel Slemrod (1990). "Optimal Taxation and Optimal Tax Systems," Journal of Economic Perspectives, 4(1), p p. 157-178.
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