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PowerPoint Lecture Notes for Chapter 8: Application: The Costs of Taxation Principles of Microeconomics 4th edition, by N.

Gregory Mankiw PowerPoint Slides by Ron Cronovich

Application: The Costs of Taxation

PRINCIPLES OF

MICROECONOMICS
F OURT H E DITIO N

N. G R E G O R Y M A N K I W
PowerPoint Slides by Ron Cronovich
2006 Thomson South-Western, all rights reserved

This chapter builds very closely on material from the previous three chapters: It uses the tools of welfare economics (from chapter 7) to analyze the effects of a tax (introduced in chapter 6). It explores the relationship between the price elasticities of demand and supply (chapter 5) with the deadweight loss of the tax. Covering this chapter immediately after the previous three will reinforce the concepts students learned in those chapters. The material in chapter 8 is important. The government must raise revenue to pay for the police, the court system, interstate highways, national defense, public education, and so forth. The government must choose which goods to tax, and how much to tax each one. Effective tax policy generates the needed revenue while striving for (the sometimes conflicting goals of) efficiency and equity. This is not one of the longer chapters; most instructors cover it in 1.5 or 2 hours of class time. But if youre pressed for time and looking for things to cut, you might consider cutting some of these (my personal suggestions, not the official recommendations of Greg Mankiw or Thomson Learning): * revenue and the size of the tax, the Laffer Curve * DWL and the size of the tax * Active Learning 3, the slide with the discussion question on whether to tax groceries or meals at fancy restaurants * Active Learning 2

In this chapter, look for the answers to these questions: How does a tax affect consumer surplus, producer
surplus, and total surplus?

What is the deadweight loss of a tax? What factors determine the size of this deadweight
loss?

How does tax revenue depend on the size of the


tax?

CHAPTER 8

APPLICATION: THE COSTS OF TAXATION

Review from chapter 6: A tax is a wedge between the price buyers pay
and the price sellers receive.

A tax raises the price buyers pay, and lowers the


price sellers receive.

A tax reduces the quantity bought & sold. These effects are the same whether the tax is
imposed on buyers or sellers, so we do not make this distinction in this chapter.

CHAPTER 8

APPLICATION: THE COSTS OF TAXATION

The effects of a tax


With no tax, eqm price is PE and quantity is QE . Govt imposes a tax of $T per unit. The price buyers pay is P B , the price sellers receive is PS , and quantity is Q T .
CHAPTER 8

Size of tax = $ T PB PE PS D S

QT

QE

APPLICATION: THE COSTS OF TAXATION

The effects of a tax


P

The tax generates revenue equal to $T x QT .


PB PE PS

Size of tax = $ T S

QT
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

QE

The effects of a tax Next, we use the tools of welfare economics to


measure the gains and losses from a tax.

We will determine consumer surplus (CS),


producer surplus (PS), tax revenue, and total surplus with and without the tax.

Tax revenue is included in total surplus,


because tax revenue can be used to provide services such as roads, police, public education, etc.

CHAPTER 8

APPLICATION: THE COSTS OF TAXATION

The effects of a tax


Without a tax, CS = A + B + C PS = D + E + F Tax revenue = 0 Total surplus = CS + PS =A+B+C +D+E+F
PE F A B D C E D S P

QT
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

QE

The effects of a tax


With the tax, CS = A PS = F Tax revenue =B+D Total surplus =A+B +D+F The tax causes total surplus to fall by C + E
CHAPTER 8

A PB B D PS F C E

QT

QE

APPLICATION: THE COSTS OF TAXATION

The effects of a tax


P

C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax.

A PB B D PS F C E

QT
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

QE

About the deadweight loss


Because of the tax, the units between QT and Q E are not sold. The value of these units to buyers is greater than the cost of producing them, so the tax has prevented some mutually beneficial trades.
CHAPTER 8

PB

PS

QT

QE

APPLICATION: THE COSTS OF TAXATION

ACTIVE LEARNING

Analysis of tax
A. Compute
$ 400

1:

P
350 300 250 200 150 100 50 0 0

The market for airplane tickets

CS, PS, and total surplus without a tax.


B. If $100 tax

In chapter 7, students learned how to compute the area of triangles representing CS, PS, and total surplus. This skill is required to do this exercise.
S

Most students will need a calculator to do part B. Your students need not draw the graph in order to do these calculations. However, if your students have handouts of these PowerPoint slides with the graphs already on them, ask your students to shade the areas corresponding to CS, PS, and so forth directly on the printed graphs.

per ticket, compute CS, PS, tax revenue, total surplus, and DWL.

Q
25 50 75 100 125
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ACTIVE LEARNING

Answers to A
CS = x $200 x 100 = $10,000
$ 400

1:

P
350 300

The market for airplane tickets

250 PS = x $200 x 100 P = 200 = $10,000 150 100 total surplus = $10,000 + $10,000 50 = $20,000 0 0 25 50

Q
75 100 125
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ACTIVE LEARNING

Answers to B
CS = x $150 x 75 = $5,625 PS = $5,625 tax revenue = $100 x 75 = $7,500 total surplus = $18,750 DWL = $1,250
$ 400

1:

P
350 300 PB = 250 200 PS = 150 100 50 0 0 25

A $100 tax on airplane tickets

To compute DWL, simply subtract total surplus with the tax ($18750) from total surplus without the tax ($20,000, which was computed on the preceding slide).
S

Q
50 75 100 125
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What determines the size of the DWL? The govt needs tax revenue to finance roads,
schools, police, etc, so it must tax some goods and services.

Which ones? One answer is that govt should tax


the goods or services with the smallest DWL.

So when is the DWL small vs. large? Turns out it


depends on the elasticities of supply and demand.

Recall: The price elasticity of demand (or supply)


measures how much quantity demanded (or supplied) changes when the price changes.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 13

DWL and the elasticity of supply


When supply is inelastic, the DWL of a tax is small.
P S

Size of tax D Q
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 14

DWL and the elasticity of supply


P

In this graph, the demand curve, equilibrium price, and size of the tax are identical to those in the graph on the preceding slide. The only thing thats different is the supply curve here is flatter; as a result, the same size tax as before causes a larger DWL.

The more elastic is supply, the larger is the DWL.

S Size of tax

D Q
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 15

DWL and the elasticity of demand


When demand is inelastic, the DWL of a tax is small.
P S Size of tax

D Q
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 16

DWL and the elasticity of demand


P S

In this graph, the supply curve, equilibrium price, and size of the tax are identical to those in the graph on the preceding slide. The only thing thats different is the demand curve here is flatter; as a result, the same size tax as before causes a larger DWL.

The more elastic is demand, the larger is the DWL.

Size of tax D

Q
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 17

Why elasticity affects the size of DWL

A tax distorts the market outcome:


consumers buy less and producers sell less, so eqm Q is below the surplus-maximizing quantity.

Elasticity measures how much buyers and


sellers respond to changes in price, and therefore determines how much the tax distorts the market outcome.

CHAPTER 8

APPLICATION: THE COSTS OF TAXATION

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ACTIVE LEARNING

2: Elasticity and DWL of a tax


Would the DWL of a tax be larger if the tax were on
A. Rice Krispies or sunscreen? B. Hotel rooms in the short run or hotel rooms in

These examples (rice krispies vs. sunscreen) were chosen not because they are exciting real-world policy debates, but because they link back to the examples used in Chapter 5 to help students deduce the factors that determine elasticity. Suggestion: Display all three questions and give students a few moments to think about it. Then, proceed to the following slides
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the long run?


C. Groceries or meals at fancy restaurants?

It might be worth mentioning to students: For each pair of goods, we are considering taxes of similar relative magnitude. (E.g., it wouldnt be fair to ask whether a $10 per bottle tax on sunscreen has a bigger DWL than a $0.01 tax on boxes of Rice Krispies.)

ACTIVE LEARNING

Answers

2:

Suggestion: Display the first line, then invite students to volunteer their answers before displaying the explanation.

A. Rice Krispies or sunscreen


From chapter 5: Rice Krispies has many more close substitutes than sunscreen, so demand for Rice Krispies is more price-elastic than demand for sunscreen. So, a tax on Rice Krispies would cause a larger DWL than a tax on sunscreen.

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ACTIVE LEARNING

Answers

2:

B. Hotel rooms in the short run or long run


From chapter 5: The price elasticities of demand and supply for hotel rooms are larger in the long run than in the short run. So, a tax on hotel rooms would cause a larger DWL in the long run than in the short run.

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ACTIVE LEARNING

Answers

2:

C. Groceries or meals at fancy restaurants


From chapter 5: Groceries are more of a necessity and therefore less price-elastic than meals at fancy restaurants. So, a tax on restaurant meals would cause a larger DWL than a tax on groceries.

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ACTIVE LEARNING

Discussion question

3:

The government must raise tax revenue to pay


for schools, police, etc. To do this, it can either tax groceries or meals at fancy restaurants.

Engage your students and give them a brief break from lecture. Show this slide and ask for students to volunteer their thoughts. The question on this slide will almost certainly elicit a few different opinions. Of course, there is no single correct answer one choice is not unambiguously better than the other. A tax on groceries would be more efficient (smaller DWL) than a tax on restaurant meals. However, a tax on groceries would hurt people with low incomes proportionately more than people with higher incomes, as the former spend a larger percentage of their income on groceries. Hence, such a tax would be regressive. Once again, we see the tradeoff between efficiency and equity.

Which should it tax?

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How big should the government be? A bigger government provides more services,
but requires higher taxes, which cause DWL.

The larger the DWL from taxation,


the greater the argument for smaller government.

The next few slides are adapted from the section Case Study: The Deadweight Loss Debate in this chapter of the textbook. The title of this slide is actually a direct quote from this section. I think it makes a catchier title for these slides than the deadweight loss debate. Why the marginal tax rate is relevant: One of the 10 Principles from Chapter 1 is rational people think at the margin. This applies to workers, as well. When Susan considers increasing her hours, she takes into account the extra income shed earn from working a few more hours a week. The extra income on each additional hour equals the hourly wage minus the marginal tax rate.

The tax on labor income is especially important,


its the biggest source of govt revenue.

For many workers, the marginal tax rate (the tax


on the last dollar of earnings) is almost 50%.

How big is the DWL from this tax?


It depends on elasticity.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 24

How big should the government be?

If labor supply is inelastic, then this DWL is


small.

Some economists believe labor supply is


inelastic, arguing that most workers work full-time regardless of the wage.

According to this view, the DWL from labor taxes is small. This is relevant to the question how big should the government be?, because a high DWL would argue for restraining the size of government.

CHAPTER 8

APPLICATION: THE COSTS OF TAXATION

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How big should the government be?


Other economists believe labor taxes are highly distorting because some groups of workers have elastic supply and can respond to incentives:

The fourth edition of the textbook has a new In The News box containing an excellent WSJ article on the effect of tax rates on work effort.

Many workers can adjust their hours, e.g. by working overtime. Many families have a 2nd earner with discretion over whether & how much to work. Many elderly choose when to retire based on the wage they earn. Some people work in the underground economy to evade high taxes.
APPLICATION: THE COSTS OF TAXATION 26

CHAPTER 8

The effects of changing the size of the tax

Policymakers often change taxes, raising some


and lowering others.

What happens to DWL and tax revenue when


taxes change? We explore this next.

CHAPTER 8

APPLICATION: THE COSTS OF TAXATION

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DWL and the size of the tax


Initially, the tax is T per unit. Doubling the tax causes the DWL to more than double.
P

The new DWL is four times the initial DWL, even though the tax is just twice as large.
S

new DWL

2T

T D

initial DWL
Q2
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Q1

Q
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APPLICATION: THE COSTS OF TAXATION

DWL and the size of the tax


Initially, the tax is T per unit. Tripling the tax causes the DWL to more than triple.
P

The new DWL is nine times the initial DWL, even though the tax is only three times as large.
S

new DWL

3T

T D

initial DWL
Q3
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Q1

Q
29

APPLICATION: THE COSTS OF TAXATION

DWL and the size of the tax


Implication Implication When When tax tax rates rates are are low, low, raising raising them them doesnt cause much doesnt cause much harm, harm, and and lowering lowering them them doesnt doesnt bring bring much much benefit. benefit. When When tax tax rates rates are are high, high, raising raising them them is is very very harmful, harmful, and and cutting cutting them them is is very very beneficial. beneficial.
CHAPTER 8

Summary When a tax increases, DWL rises even more.


DWL

The implication in the green box is not in the textbook, and therefore not supported in the study guide or test bank. So, you may wish to delete it from this slide. If you keep it, note that the harm of raising taxes and the benefit of lowering them refer to the impact on total surplus.

Tax size
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APPLICATION: THE COSTS OF TAXATION

Revenue and the size of the tax


When the tax is small, increasing it causes tax revenue to rise.
P

PB PB 2T PS PS T

Q2
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Q1

Q
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APPLICATION: THE COSTS OF TAXATION

Revenue and the size of the tax


P PB PB S 3T 2T D PS PS Q3
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When the tax is larger, increasing it causes tax revenue to fall.

Q2

Q
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APPLICATION: THE COSTS OF TAXATION

Revenue and the size of the tax


The Laffer curve Tax shows the revenue relationship between the size of the tax and tax revenue. The Laffer curve

The Laffer curves shown here and in the book are symmetric, and their peak occurs in the middle. This need not be the case, and probably is not the case. However, we just dont know where the peak is it could be at a tax rate of 20% or a tax rate of 200% - and surely varies across goods. The textbook has some excellent discussion of the Laffer curve, President Reagan, and supply-side economics, which you should encourage your students to read.
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Tax size

CHAPTER 8

APPLICATION: THE COSTS OF TAXATION

CHAPTER SUMMARY A tax on a good reduces the welfare of buyers and


sellers. This welfare loss usually exceeds the revenue the tax raises for the govt.

The fall in total surplus (consumer surplus,


producer surplus, and tax revenue) is called the deadweight loss (DWL) of the tax.

A tax has a DWL because it causes consumers to


buy less and producers to sell less, thus shrinking the market below the level that maximizes total surplus.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 34

CHAPTER SUMMARY The price elasticities of demand and supply


measure how much buyers and sellers respond to price changes. Therefore, higher elasticities imply higher DWLs.

An increase in the size of a tax causes the DWL to


rise even more.

An increase in the size of a tax causes revenue to


rise at first, but eventually revenue falls because the tax reduces the size of the market.

CHAPTER 8

APPLICATION: THE COSTS OF TAXATION

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