N.

GREGORY MANKIW
PRINCIPLES OF

ECONOMICS
Eight Edition

CHAPTER Application:
8 The Costs of Taxation
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Eastern Illinois University
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Review from Chapter 6

• A tax
–…

– Raises the price buyers pay and lowers

the price sellers receive
– Reduces the quantity bought and sold
• These effects are the same
– Whether the tax is imposed on buyers or
sellers
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The Effects of a Tax

Revenue from tax:
P …
Equilibrium with
no tax:
• Price = PE Size of tax = $T
• Quantity = QE PB S

PE
Equilibrium with
tax = $T per unit: PS D
• Buyers pay PB
• Sellers receive PS
• Quantity = QT
Q
QT QE

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1
 The Effects of a Tax
Without a tax, P
CS = …
PS = …
Tax revenue = … A
Total surplus S
=… B C
PE
D E
D
F

Q
QT QE

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The Effects of a Tax

C + E is called the deadweight
With the tax, loss (DWL) of the tax,
CS = … P
PS = …
Tax revenue = …D
Total surplus A
PB S
=…
B C
D E
The tax reduces total
PS D
surplus by …
F

QE – QT = …
Q
QT QE
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Active Learning 1 Analysis of a tax

A. Compute CS, P
$ The market for
PS, and total 400 airplane tickets
surplus without a 350
tax.
300
B. If $100 tax per S
250
ticket, compute
200
CS, PS, tax
revenue, total 150
D
surplus, and 100
DWL. 50
0 Q
0 25 50 75 100 125
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2
 Active Learning 1 A. Answers
A. Without tax: P
The market for
CS = $ 400
airplane tickets
350
300
PS = S
250
P = 200
150
TS = D
100
50
0 Q
0 25 50 75 100 125
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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 7
management system for classroom use.

Active Learning 1 B. Answers

P
B. With tax: A $100 tax on
$ 400
airplane tickets
CS = 350
300
PS = S
PB = 250
Tax revenue
200
=
PS = 150
D
100
TS = 50
DWL = 0 Q
0 25 50 75 100 125
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Determinants of Deadweight Loss

• Price elasticities of supply and demand
– More elastic supply curve
• _________ deadweight loss
– More elastic demand curve
• _________ deadweight loss
• The greater the elasticities of supply and
demand
– The …

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3
 DWL and the Elasticity of Supply

When supply is P
inelastic,
S

Size
of tax

D
Q

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DWL and the Elasticity of Supply

The more elastic is
supply,
P

S
Size
of tax

D
Q

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DWL and the Elasticity of Demand

When demand is
P inelastic,

Size
of tax

D
Q

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4
 DWL and the Elasticity of Demand
The more elastic is
demand,
P

Size
of tax
D

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Active Learning 2 Elasticity and the DWL

Would the DWL of a tax be larger if the
tax were on:
A. Breakfast cereal or sunscreen?
B. Hotel rooms in the short run or hotel rooms
in the long run?
C. Groceries or meals at fancy restaurants?

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Active Learning 3 Discussion question

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.
• Which should it tax?

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5
 How Big Should the Government Be?
• A bigger government
– Provides more services, but requires
higher taxes, which cause DWLs
– The larger the DWL from taxation, the
greater the argument for smaller
government
• Tax on labor income - especially important
– Biggest source of government revenue
• Marginal tax rate: about 40%
• How big is the DWL?
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How Big Should the Government Be?

• 40% labor tax - Small or large
deadweight loss?

“What’s your
• Some believe labor supply is position on the
elasticity of labor
…… supply?”

– Almost vertical: …

– Tax on labor: …
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How Big Should the Government Be?

• Others: labor supply is …
– Labor taxes are highly distorting: …

– Tax on labor: …
• Many workers can adjust their hours
• Some families have 2nd earners; some
discretion over whether and how much to work
• Many of the elderly can choose when to retire
• Some people work in the “underground
economy” to evade high taxes

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6
 ASK THE EXPERTS
The Laffer Curve
“A cut in federal income tax rates in the United
States right now would lead to higher national
income within five years than without the tax
cut.”

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Effects of Changing the Size of the Tax

• As the tax increases
– Deadweight loss _________
• Even more rapidly than the size of the tax
– Tax revenue
• ____________initially
• Then ___________
• The higher tax: drastically reduces the size of
the market

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DWL and the Size of the Tax

P
Initially, the tax is T
per unit.
S
Doubling the tax…
T

D
initial
DWL

Q
Q1

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7
 DWL and the Size of the Tax

Initially, the tax is T P

per unit.

Tripling the tax S

… T

D
initial
DWL

Q
Q1

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DWL and the Size of the Tax

Implication Summary
When tax rates are When a tax increases,
low, raising them DWL rises even more.
doesn’t cause much DWL
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. Tax size
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Revenue and the Size of the Tax

When the P
tax is small, …

S
PB
T
PS D

Q
Q1

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 24
management system for classroom use.

8
 Revenue and the Size of the Tax

Tax
The Laffer curve
The Laffer curve
… revenue

Tax size

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 25
management system for classroom use.

ASK THE EXPERTS

The Laffer Curve
“A cut in federal income tax rates in the United
States right now would raise taxable income
enough so that the annual total tax revenue
would be higher within five years than without
the tax cut.”

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 26
management system for classroom use.