Application: The Costs of Taxation

8

Copyright©2004 South-Western

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

Copyright © 2004 South-Western/Thomson Learning

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

Copyright © 2004 South-Western/Thomson Learning

Copyright © 2004 South-Western/Thomson Learning . .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 Price Supply Price buyers pay Price without tax Size of tax Price sellers receive Demand 0 Quantity with tax Quantity without tax Quantity Copyright © 2004 South-Western .

How a Tax Affects Market Participants • A tax places a wedge between the price buyers pay and the price sellers receive. Copyright © 2004 South-Western/Thomson Learning . • Because of this tax wedge. • The size of the market for that good shrinks. the quantity sold falls below the level that would be sold without a tax.

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 Copyright © 2004 South-Western/Thomson Learning .

Figure 2 Tax Revenue Price Supply Price buyers pay Tax revenue (T × Q) Price sellers receive Quantity sold (Q) 0 Quantity with tax Size of tax (T) Demand Quantity without tax Quantity Copyright © 2004 South-Western .

Figure 3 How a Tax Effects Welfare Price Price buyers = PB pay Price without tax = P1 Price sellers = PS receive A Supply B C E D F Demand 0 Q2 Q1 Quantity Copyright © 2004 South-Western .

Copyright © 2004 South-Western/Thomson Learning . such as a tax.How a Tax Affects Market Participants • Changes in Welfare • A deadweight loss is the fall in total surplus that results from a market distortion.

How a Tax Affects Welfare Copyright © 2004 South-Western/Thomson Learning .

The losses to buyers and sellers exceed the revenue raised by the government. and The change in tax revenue. Copyright © 2004 South-Western/Thomson Learning . • This fall in total surplus is called the deadweight loss. The change in producer surplus.How a Tax Affects Market Participants • The change in total welfare includes: • • • • The change in consumer surplus.

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. Copyright © 2004 South-Western/Thomson Learning .

Figure 4 The Deadweight Loss Price PB Size of tax Price without tax PS Lost gains from trade Supply Value to buyers 0 Q2 Q1 Cost to sellers Demand Quantity Reduction in quantity due to the tax Copyright © 2004 South-Western .

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. Copyright © 2004 South-Western/Thomson Learning .

Figure 5 Tax Distortions and Elasticities (a) Inelastic Supply Price Supply When supply is relatively inelastic. the deadweight loss of a tax is small. Size of tax Demand 0 Quantity Copyright © 2004 South-Western .

the deadweight loss of a tax is large.Figure 5 Tax Distortions and Elasticities (b) Elastic Supply Price When supply is relatively elastic. Size of tax Supply Demand 0 Quantity Copyright © 2004 South-Western .

Figure 5 Tax Distortions and Elasticities (c) Inelastic Demand Price Supply Size of tax When demand is relatively inelastic. Demand 0 Quantity Copyright © 2004 South-Western . the deadweight loss of a tax is small.

0 Demand Quantity Copyright © 2004 South-Western . the deadweight loss of a tax is large.Figure 5 Tax Distortions and Elasticities (d) Elastic Demand Price Supply Size of tax When demand is relatively elastic.

Copyright © 2004 South-Western/Thomson Learning . • the greater the deadweight loss of a tax.DETERMINANTS OF THE DEADWEIGHT LOSS • The greater the elasticities of demand and supply: • the larger will be the decline in equilibrium quantity and.

e..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. those engaging in illegal activity) Copyright © 2004 South-Western/Thomson Learning .

DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY • With each increase in the tax rate. Copyright © 2004 South-Western/Thomson Learning . 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 (a) Small Tax Price Deadweight loss Supply PB Tax revenue PS Demand 0 Q2 Q1 Quantity Copyright © 2004 South-Western .

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes (b) Medium Tax Price Deadweight loss Supply Tax revenue PB PS Demand 0 Q2 Q1 Quantity Copyright © 2004 South-Western .

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes (c) Large Tax Price PB Deadweight loss Tax revenue Supply Demand PS 0 Q2 Q1 Quantity Copyright © 2004 South-Western .

• But as the size of the tax continues to rise. Copyright © 2004 South-Western/Thomson Learning . tax revenue falls because the higher tax reduces the size of the market. tax revenue grows. • As the size of the tax rises. tax revenue is small.DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY • For the small tax.

Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (a) Deadweight Loss Deadweight Loss 0 Tax Size Copyright © 2004 South-Western .

Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (b) Revenue (the Laffer curve) Tax Revenue 0 Tax Size Copyright © 2004 South-Western .

• By contrast. the market shrinks so much that tax revenue starts to fall.DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY • As the size of a tax increases. but then. as the tax gets larger. its deadweight loss quickly gets larger. Copyright © 2004 South-Western/Thomson Learning . tax revenue first rises with the size of a tax.

CASE STUDY: The Laffer Curve and Supplyside 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. Copyright © 2004 South-Western/Thomson Learning .

and tax revenue — is called the deadweight loss of the tax. producer surplus. • The fall in total surplus—the sum of consumer surplus.Summary • A tax on a good reduces the welfare of buyers and sellers of the good. Copyright © 2004 South-Western/Thomson Learning . and the reduction in consumer and producer surplus usually exceeds the revenues raised by the government.

• This change in behavior shrinks the size of the market below the level that maximizes total surplus. Copyright © 2004 South-Western/Thomson Learning .Summary • Taxes have a deadweight loss because they cause buyers to consume less and sellers to produce less.

Summary • As a tax grows larger. • Eventually. Copyright © 2004 South-Western/Thomson Learning . • Tax revenue first rises with the size of a tax. and its deadweight loss grows larger. however. it distorts incentives more. a larger tax reduces tax revenue because it reduces the size of the market.

3908041909.803909.90 90 /0./0948841909.70.78080.3.032470 7.% $$% #'&$%$'# W 90..5/9. 4579 $4:9 089073.7.

%42843 0.733 .

3/%.3/ " " ":.03:0 !$ 02.#0.08411107039$08 .70. $2.399 4579 $4:9 089073 . !7./09 488 $:55 ! %.03:01742%700 %./09488.:700.0 0.%.

3/ " " ":.03:0 ! !$ 02./09 488 $:55 %.70.399 4579 $4:9 089073 .:700.03:01742%700 %. !7.0 0.0/:2%.#0./09488.3/%.08411107039$08 .

 !7./09 488 %.:700. ./09488.03:0 $:55 02.03:01742%700 %.3/ !$ " " ":.70%.70.08411107039$08 .#0.0 ! 0.3/%.399 4579 $4:9 089073 .

709 4579 $4:9 089073..0890 8041902.8908041909.:8090079.03:0748 W :9.70.03:0882.7808 9. 9.03:01. W 8908041909.% $$% #'&$%$'# W 479082.70/:. 70.9.8-0.4393:0894780 9.70..

%42843 0.733 .

0./09488.%.7 990$041.3/%./09488 0.$0 4579 $4:9 089073 ./09 488 %.03:0'.#0. .:7040.

#0.$0 4579 $4:9 089073 .:7. #0.#0./09488.7 990$041. .1107.03:0 %.3/%.0 %.03:0 90.03:0'.%.:7040.

707 90 2.9.3.70.70.99.4397.098.9.% $$% #'&$%$'# W 8908041.7098738842:. 4579 $4:9 089073.707 W .70.098.8909.03:01789780899080 41. -:9903 .798 941.808 98/0.89 9.9./09 4886:.03:089.

733 .%42843 0.

3/9070- .4342.9.809..3.8 W %0.8 7010789490.70.03:08 4579 $4:9 089073.:9 4:/3/:.94385 -090039.9.3/9.090549039.989070.943.70.:7.908.3/.1107.7..02470504509447.70.0841 #0.3/$:55 8/0..0 /05.4342.1107:7.$$%&%0.03:0 W $:55 8/00.110745745480/9.0.

%42843 0.733 .

03:0 8 .3949.03:087.089001.3/574/:.9433 .438:207 8:75:8 574/:.078:75:8:8:.$:22.7041-:078 .43.44/70/:.3/9070/:./0948841909.3/9..8:75:8 908:241.0732039 W %01.80/-904.078:75:8 .0.7 W 9.0/90/0.00/8 9070.3/80078419044/ .438:207.70. 4579 $4:9 089073.

%42843 0.733 .

:80-:07894.$:22.208949.92...0088 W %8.:8090 ../0./09488-0.47873890804190 2.438:20088..709-04900. 8:75:8 4579 $4:9 089073.0..3/8007894 574/:.09.7 W %.303-0.08.

%42843 0.733 .

7 W 8.70/:..707 W %..$:22.9.9.08 2470 .039:. 70.07 .748. 40.0890804190 2.3/98/0.7079.:80970/:.709 4579 $4:9 089073. W .039.03:0-0.707 9/8947983.03:0178978089908041.70./09488748.089.

%42843 0.733 .

Sign up to vote on this title
UsefulNot useful