Application,
the Costs of Taxation
Chapter 8
The Cost of Taxation
How do taxes affect the economic well-
being of market participants?
It does not matter whether a tax on a good
is levied on buyers or sellers of the good…
the price paid by buyers rises,and the
price received by sellers falls.
The Effects of a Tax...
Price
0 QuantityQuantity without
tax
Supply
Demand
Price
without tax
Price buyers
pay
Quantity
with tax
Size of tax
Price sellers
receive
The Effects of a Tax
A tax places a wedge between the price
buyers pay and the price sellers receive.
Because of this tax wedge,the quantity
sold falls below the level that would be
sold without a tax.
The size of the market for that good
shrinks
Tax Revenue
T = the size of the tax
Q = the quantity of the good sold
T?Q = the government’s tax revenue
Tax Revenue...
Price
0 QuantityQuantity without
tax
Supply
Demand
Price sellers
receive
Quantity
with tax
Size of tax (T)
Quantity
sold (Q)
Tax
Revenue
(T x Q)
Price buyers
pay
How a Tax Affects Welfare...
Quantity0
Price
Demand
Supply
Q1
A
B C
F
D E
Q2
Tax reduces consumer surplus by (B+C) and
producer surplus by (D+E)
Tax revenue = (B+D)
Deadweight Loss = (C+E)
Price
buyers
pay = PB
P1
Price
without
tax
=
PSPrice
sellers
receive
=
Changes in Welfare
from a Tax
Without Tax With Tax Change
Consumer Surplus A + B + C A - (B + C)
Producer Surplus D + E + F F - (D + E)
Tax Revenue none B + D + (B + D)
Total Surplus A + B + C + D + E + F A + B + D + F - (C + E )
The area C+E shows the fall in total surplus
is the deadweight loss of the tax.
How a Tax affects welfare
The change in total welfare includes:
The change in consumer surplus.
The change in producer surplus.
The change in tax revenue.
The losses to buyers and sellers exceed the
revenue raise by the government.
The fall in total surplus is called the
deadweight loss.
Deadweight Loss and the
Gains from Trade
Taxes cause deadweight losses because
they prevent buyers and sellers from
realizing some of the gains from trade.
The Deadweight Loss...
Quantity0
Price
Demand
Supply
Q1
PB
Price = P1
without tax
PS
Q2
Size of tax
Lost gains from
trade
Cost to
sellers
Value to
buyers
Reduction in quantity due to the tax
Determinants of Deadweight Loss
What determines whether the deadweight
loss from a tax is small or large?
The magnitude of the deadweight loss
depends on how much the quantity
supplied and quantity demanded respond
to changes in the price,
That,in turn,depends on the price
elasticities of supply and demand.
Tax Distortions and Elasticities...
Quantity
Price
Demand
Supply
0
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
(a) Inelastic Supply
Size
of tax
Quantity
Price
Demand
Supply
0
Size
of tax
When supply is
relatively elastic,
the deadweight loss
of a tax is large.
(b) Elastic Supply
Tax Distortions and Elasticities...
Quantity
Price
Demand
Supply
0
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
(c) Inelastic Demand
Size
of tax
Tax Distortions and Elasticities...
Quantity
Price
Demand
Supply
0
Size
of tax
When demand is
relatively elastic,
the deadweight loss
of a tax is large.
(d) Elastic Demand
Tax Distortions and Elasticities...
Determinants of Deadweight Loss
The greater the elasticities of supply and
demand
The larger will be the decline in the
equilibrium quantity and,
The greater the deadweight loss of a tax.
The Deadweight Loss Debate
Some economists argue that labor taxes are
highly distorting and believe that labor supply is
more elastic,
Some examples of workers who may respond
more to incentives.
Workers who can adjust the number of hours
they work.
Families with second earners
Elderly who can choose when to retire.
Workers in the underground economy.
Deadweight Loss and Tax Revenue
as Tax Vary
With each increase in the tax rate,the
deadweight loss of the tax rises even more
rapidly than the size of the tax.
Deadweight Loss and Tax Revenue.
PB
QuantityQ20
Price
Q1
Demand
Supply
Tax revenue
PS
Deadweight
loss
(a) Small Tax
Demand
Supply
Tax
revenue
PB
QuantityQ20
Price
Q1
PS
Deadweight
loss
(b) Medium Tax
Deadweight Loss and Tax Revenue.
Deadweight Loss and Tax Revenue.
PB
QuantityQ20
Price
Q1
Demand
Supply
PS
Deadweight
loss
(c) Large Tax
Deadweight Loss and Tax Revenue
For the small tax,tax revenue is small.
As the size of the tax rises,tax revenue
grows.
But as the size of the tax continue to rise,
tax revenue falls because the higher tax
reduces the size of the market.
Deadweight Loss and Tax Revenue
Vary with the Size of the Tax...
(a) Deadweight Loss
Deadweight
Loss
0 Tax Size
(b) Revenue (the Laffer curve)Tax
Revenue
0 Tax Size
Deadweight Loss and Tax Revenue
Vary with the Size of the Tax...
As the size of a tax increases,its
deadweight loss quickly gets larger.
By contrast,tax revenue first rises with the
size of a tax; but then,as the tax gets larger,
the market shrinks so much that tax
revenue starts to fall.
Deadweight Loss and Tax Revenue
Vary with the Size of the Tax...
The Laffer Curve and
Supply-side Economics
The Laffer curve depicts the relationship
between tax rate and tax revenue.
Supply-side economics refers to the views
of Reagan and Laffer who proposed that a
tax cut would induce more people to work
and thereby have the potential to increase
tax revenues.
Summary
A tax on a good reduces the welfare of
buyers and sellers of the good,And the
reduction in consumer and producer
surplus usually exceeds the revenues
raised by the government.
The fall in total surplus – the sum of
consumer surplus,producer surplus,and
tax revenue – is called the deadweight loss
of the tax.
Summary
Taxes have a deadweight loss because
they cause buyers to consume less and
sellers to produce less.
This change in behavior shrinks the size of
the market below the level that maximizes
total surplus.
Summary
As a tax grows larger,it distorts incentives
more,and its deadweight loss grows
larger.
Tax revenue first rises with the size of a
tax.
Eventually,however,a larger tax reduces
tax revenue because it reduces the size of
the market
Exercise #8
Problems and Applications
– #1,#5,#7,#13