Application: The Costs of taxation

Application: The Costs of Taxation
Welfare economics is the study of how the allocation of resources affects economic well-being.
Buyers and sellers receive benefits from taking part in the market.
The equilibrium in a market maximizes the total welfare of buyers and sellers.

THE DEADWEIGHT LOSS OF TAXATION
How do taxes affect the economic well-being of market participants?

THE DEADWEIGHT LOSS OF TAXATION
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.

Figure 1 The Effects of a Tax
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How a Tax Affects Market Participants
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.

How a Tax Affects Market Participants
Tax Revenue
T = the size of the tax
Q = the quantity of the good sold
T × Q = the government’s tax revenue

Figure 2 Tax Revenue
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Figure 3 How a Tax Effects Welfare
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How a Tax Affects Market Participants
Changes in Welfare
A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax.

How a Tax Affects Welfare

How a Tax Affects Market Participants
The change in total welfare includes:
The change in consumer surplus,
The change in producer surplus, and
The change in tax revenue.
The losses to buyers and sellers exceed the revenue raised by the government.
This fall in total surplus is called the deadweight loss.

Deadweight Losses and the Gains from Trade
Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.

Figure 4 The Deadweight Loss
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DETERMINANTS OF THE DEADWEIGHT LOSS
What determines whether the deadweight loss from a tax is large or small?
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.

Figure 5 Tax Distortions and Elasticities
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(a) Inelastic Supply
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Figure 5 Tax Distortions and Elasticities
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(b) Elastic Supply
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Figure 5 Tax Distortions and Elasticities
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(c) Inelastic Demand
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Figure 5 Tax Distortions and Elasticities
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(d) Elastic Demand
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DETERMINANTS OF THE DEADWEIGHT LOSS
The greater the elasticities of demand and supply: the larger will be the decline in equilibrium quantity and,
the greater the deadweight loss of a tax.

DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY
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 (i.e., those engaging in illegal activity)

DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY
With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax.

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
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(a) Small Tax

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
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(b) Medium Tax

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
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(c) Large Tax

DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY
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 continues to rise, tax revenue falls because the higher tax reduces the size of the market.

Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax
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(a) Deadweight Loss
Deadweight
Loss
0
Tax Size

Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax
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(b) Revenue (the Laffer curve)
Tax
Revenue
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Tax Size

DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY
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.

CASE STUDY: The Laffer Curve and Supply-side Economics
The Laffer curve depicts the relationship between tax rates 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.