CHAPTER 8: THE COST OF TAXATION WHAT DETERMINES THE SIZE OF DEADWEIGHT

LOSS?
A TAX
 The govt needs tax revenue to finance
 is a wedge between the price buyers
roads, schools, police, etc., so it must
pay and the price sellers receive
tax some goods and services.
 raises the price buyers pay and lowers
 Which ones? One answer is that govt
the price sellers receive.
should tax the goods or services with
 reduces the quantity bought & sold.
the smallest DWL.
THE EFFECTS OF TAX  So when is the DWL small vs. large?
Turns out it depends on the elasticities
 With no tax, equilibrium price is PE and of supply and demand.
quantity is QE  Recall: The price elasticity of demand
 Govt imposes a tax of $T per unit. the (or supply) measures how much
price sellers receive is PS, and quantity quantity demanded (or supplied)
is QT. The price buyers pay is PB, The changes when the price changes.
price sellers receive is PS ,and quantity
is QT . DEADWEIGHT LOSS AND THE ELASTICITY OF
 The tax generates revenue equal to $T x SUPPLY
QT
 When supply is inelastic, the DWL of a
 We will determine consumer surplus
tax is small
(CS), producer surplus (PS), tax revenue,
 The more elastic is supply, the larger is
and total surplus with and without the
the DWL
tax.
 When demand is inelastic, the DWL of a
 Tax revenue is included in total surplus,
tax is small
because tax revenue can be used to
 The more elastic is demand, the larger
provide services such as roads, police,
is the DWL
public education, etc.
 C + E is called the deadweight loss WHY ELASTICITY AFFECTS THE SIZE OF DWL
(DWL) of the tax, the fall in total surplus
 A tax distorts the market outcome:
that results from a market distortion,
consumers buy less and producers sell
such as a tax.
less, so equilibrium Q is below the
ABOUT THE DEADWEIGHT LOSS surplus-maximizing quantity.
 Elasticity measures how much buyers
 Because of the tax, the units between
and sellers respond to changes in price,
QT and QE are not sold. The value of
and therefore determines how much
these units to buyers is greater than the
the tax distorts the market outcome.
cost of producing them, so the tax has
prevented some mutually beneficial HOW BIG SHOULD THE GOVERNMENT BE?
trades.
 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
REVENUE AND THE SIZE OF THE TAX
government.
 The tax on labor income is especially  When the tax is small, increasing it
important; it’s the biggest source of causes tax revenue to rise.
govt revenue.  When the tax is larger, increasing it
 For many workers, the marginal tax rate causes tax revenue to fall.
(the tax on the last dollar of earnings) is  The Laffer curve shows the
almost 50%. relationship between the size of the
 How big is the DWL from this tax? It tax and tax revenue.
depends on elasticity.
 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.

THE EFFECTS OF CHANGING THE SIZE OF THE

TAX

 Policymakers often change taxes,

raising some and lowering others.

DWL AND THE SIZE OF THE TAX

 Initially, the tax is T per unit.

 Doubling the tax causes the DWL to
more than double.

 Initially, the tax is T per unit.

 Tripling the tax causes the DWL to more
than triple.

IMPLICATION:

 When tax rates are low, raising them

doesn’t cause much harm, and lowering
them doesn’t bring much benefit.
 When tax rates are high, raising them is
very harmful, and cutting them is very
beneficial.
 When a tax increases, DWL rises even
more