Chapter Application: The Costs of Taxation

The Deadweight Loss of Taxation
Tax on a good
Levied on buyers
Demand curve shifts downward by the size of tax
Levied on sellers
Supply curve shifts upward by the size of tax
Same outcome: price wedge
Price paid by buyers – rises
Price received by sellers – falls
Lower quantity sold

The Deadweight Loss of Taxation
Tax burden
Distributed between producers and consumers
Determined by elasticities of supply and demand
Market for the good - smaller

The effects of a tax
1
A tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls.

The Deadweight Loss of Taxation
How a tax affects market participants
Gains and losses from a tax on a good
Buyers: consumer surplus
Sellers: producer surplus
Government: total tax revenue
Tax times quantity sold
Public benefit from the tax

Tax revenue
2
The tax revenue that the government collects equals T × Q, the size of the tax T times the quantity sold Q. Thus, tax revenue equals the area of the rectangle between the supply and demand curves
Tax
revenue
T ˣ Q

The Deadweight Loss of Taxation
Welfare without a tax
Consumer surplus
Producer surplus
Total tax revenue = 0
Welfare with tax
Smaller consumer surplus
Smaller producer surplus
Total tax revenue
Smaller overall welfare

How a tax affects welfare
3
A tax on a good reduces consumer surplus (by the area B + C) and producer surplus
(by the area D + E). Because the fall in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a deadweight loss (area C + E).
A
B
D
F

The Deadweight Loss of Taxation
Losses of surplus to buyers and sellers from a tax
Exceed the revenue raised by the government
Deadweight loss
Fall in total surplus that results from a market distortion, such as a tax
Taxes distort incentives
Markets allocate resources inefficiently

The Deadweight Loss of Taxation
Deadweight losses and the gains from trade
Taxes cause deadweight losses
Prevent buyers and sellers from realizing some of the gains from trade
The gains from trade
Difference between buyers’ value and sellers’ cost
Less than the tax
Once the tax is imposed
Trades are not made
Deadweight loss

The deadweight loss
4
When the government imposes a tax on a good, the quantity sold falls from Q1 to Q2. At every quantity between Q1 and Q2, the potential gains from trade among buyers and sellers are not realized. These lost gains from trade create the deadweight loss.

Determinants of the Deadweight Loss
Price elasticities of supply and demand
Supply curve - more elastic
Deadweight loss – larger
Demand curve – more elastic
Deadweight loss – larger
The greater the elasticities of supply and demand
The greater the deadweight loss of a tax

Tax distortions and elasticities (a, b)
5
(a) Inelastic supply
In panels (a) and (b), the demand curve and the size of the tax are the same, but the price elasticity of supply is different. Notice that the more elastic the supply curve, the larger the deadweight loss of the tax.
(b) Elastic supply

Tax distortions and elasticities (c, d)
5
(c) Inelastic demand
In panels (c) and (d), the supply curve and the size of the tax are the same, but the price elasticity of demand is different. Notice that the more elastic the demand curve, the larger the deadweight loss of the tax.
(d) Elastic demand

How big should the government be?
The larger the deadweight loss of taxation
The larger the cost of any government program
If taxes - large deadweight losses
These losses - strong argument for a leaner government
Does less and taxes less
If taxes - small deadweight losses
Government programs - less costly
The deadweight loss debate

How big are the deadweight losses of taxation?
Economists disagree
Tax on labor
Social Security tax, Medicare tax, federal income tax
Places a wedge between the wage that firms pay and the wage that workers receive
Marginal tax rate on labor income = 40%
The deadweight loss debate

40% labor tax - Small or large deadweight loss?
Labor supply - fairly inelastic
Almost vertical
Tax on labor - small deadweight loss
Labor supply - more elastic
Tax on labor – greater deadweight loss
The deadweight loss debate

Deadweight Loss & Tax Revenue as Taxes Vary
As the tax increases
Deadweight loss increases
Even more rapidly than the size of the tax
Tax revenue
Increases initially
Then decreases
Higher tax – drastically reduces the size of the market

How deadweight loss and tax revenue vary with the size of a tax (a, b, c)
6
(a) Small tax
The deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the amount of the tax times the amount of the good sold. In panel (a), a small tax has a small deadweight loss and raises a small amount of revenue. In panel (b), a somewhat larger tax has a larger deadweight loss and raises a larger amount of revenue. In panel (c), a very large tax has a very large deadweight loss, but because it has reduced the size of the market so much, the tax raises only a small amount of revenue.
Tax
revenue
(b) Medium tax
Tax
revenue
(c) Large tax
Tax revenue

How deadweight loss and tax revenue vary with the size of a tax (d, e)
6
(d) From panel (a) to panel (c),
deadweight loss continually increases
Panels (d) and (e) summarize these conclusions. Panel (d) shows that as the size of a tax grows larger, the deadweight loss grows larger. Panel (e) shows that tax revenue first rises and then falls. This relationship is sometimes called the Laffer curve.
(e) From panel (a) to panel (c), tax
revenue first increases, then decreases

1974, economist Arthur Laffer
Laffer curve
Supply-side economics
Tax rates were so high
Reducing them would actually raise tax revenue
Ronald Reagan - ran for president in 1980
From experience in film industry
High tax rates - caused less work
Low tax rates - caused more work
The Laffer curve and supply-side economics