The Costs of Taxation Chapter

The Costs of Taxation
How do taxes affect the economic well-being of market participants?

The Costs 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.

The Effects of a Tax...
Price
0
Quantity
Supply
Demand

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
Quantity
Quantity without tax
Supply
Demand
Price sellers receive
Quantity with tax
Price buyers pay

How a Tax Affects Welfare...
Quantity
0
Price
Demand
Supply
Q1
Q2
Tax reduces consumer surplus by (B+C) and producer surplus by (D+E)
Tax revenue = (B+D)
Deadweight Loss = (C+E)

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 and 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 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.

The Deadweight Loss...
Quantity
0
Price
Demand
Supply
Q1
PB
Price = P1
without tax
PS
Q2

Determinants of 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.

Tax Distortions and Elasticities...
Quantity
Price
Demand
Supply
0
(a) Inelastic Supply

Tax Distortions and Elasticities...
Quantity
Price
Demand
Supply
0
(b) Elastic Supply

Tax Distortions and Elasticities...
Quantity
Price
Demand
Supply
0
(c) Inelastic Demand

Tax Distortions and Elasticities...
Quantity
Price
Demand
Supply
0
(d) Elastic Demand

Determinants of 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.

The Deadweight Loss Debate
Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic.

The Deadweight Loss Debate
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.

Deadweight Loss and Tax Revenue...
PB
Quantity
Q2
0
Price
Q1
Demand
Supply
PS
(a) Small Tax

Demand
Supply
PB
Quantity
Q2
0
Price
Q1
PS
Deadweight Loss and Tax Revenue...
(b) Medium Tax

PB
Quantity
Q2
0
Price
Q1
Demand
Supply
PS
Deadweight Loss and Tax Revenue...
(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 continues 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

Deadweight Loss and Tax Revenue Vary with the Size of the Tax...
(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.

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.

Summary
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.

The Effects of a Tax...
Price
0
Quantity
Supply
Demand

Tax Revenue...
Price
0
Quantity
Quantity without tax
Supply
Demand
Price sellers receive
Quantity with tax
Price buyers pay

How a Tax Affects Welfare...
Quantity
0
Price
Demand
Supply
Q1
Q2
Tax reduces consumer surplus by (B+C) and producer surplus by (D+E)
Tax revenue = (B+D)
Deadweight Loss = (C+E)

The Deadweight Loss...
Quantity
0
Price
Demand
Supply
Q1
PB
Price = P1
without tax
PS
Q2

Tax Distortions and Elasticities...
Quantity
Price
Demand
Supply
0
(a) Inelastic Supply

Tax Distortions and Elasticities...
Quantity
Price
Demand
Supply
0
(b) Elastic Supply

Tax Distortions and Elasticities...
Quantity
Price
Demand
Supply
0
(c) Inelastic Demand

Tax Distortions and Elasticities...
Quantity
Price
Demand
Supply
0
(d) Elastic Demand

Deadweight Loss and Tax Revenue...
PB
Quantity
Q2
0
Price
Q1
Demand
Supply
PS
(a) Small Tax

Demand
Supply
PB
Quantity
Q2
0
Price
Q1
PS
Deadweight Loss and Tax Revenue...
(b) Medium Tax

PB
Quantity
Q2
0
Price
Q1
Demand
Supply
PS
Deadweight Loss and Tax Revenue...
(c) Large Tax

Deadweight Loss and Tax Revenue Vary with the Size of the Tax...
(a) Deadweight Loss
Deadweight
Loss
0
Tax Size