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Copyright2004 South-Western
8Application: The
Costs of Taxation
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Copyright 2004 South-Western/Thomson Learning
Application: The Costs of Taxation Welfare economics is the study of how the
allocation ofresources affects economic well-
being.
Buyers and sellers receive benefits from taking partin the market.
The equilibrium in a market maximizes the total
welfare of buyers and sellers.
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Copyright 2004 South-Western/Thomson Learning
THE DEADWEIGHT LOSS OFTAXATION
How do taxes affect the economic well-being of
market participants?
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Copyright 2004 South-Western/Thomson Learning
THE DEADWEIGHT LOSS OFTAXATION
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, andthe price received by
sellers falls.
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Figure 1 The Effects of a Tax
Copyright 2004 South-Western
Size of tax
Quantity0
Price
Price buyers
pay
Price sellers
receive
Demand
Supply
Price
without tax
Quantity
without tax
Quantity
with tax
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Copyright 2004 South-Western/Thomson Learning
How a Tax Affects Market Participants 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 withouta tax.
The size of the market for that good shrinks.
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Copyright 2004 South-Western/Thomson Learning
How a Tax Affects Market Participants
Tax Revenue T= the size of the tax
Q= the quantity of the good sold
TQ= the governments tax revenue
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Figure 2 Tax Revenue
Copyright 2004 South-Western
Taxrevenue
(T Q)
Size of tax (T)
Quantity
sold (Q)
Quantity0
Price
Demand
Supply
Quantity
without tax
Quantity
with tax
Price buyers
pay
Price sellers
receive
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Figure 3 How a Tax Effects Welfare
Copyright 2004 South-Western
A
F
B
D
C
E
Quantity0
Price
Demand
Supply
= PB
Q2
= PS
Pricebuyers
pay
Pricesellers
receive
= P1
Q1
Pricewithout tax
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How a Tax Affects Market Participants Changes in Welfare
A deadweight loss is the fall in total surplus that
results from a market distortion, such as a tax.
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How a Tax Affects Welfare
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How a Tax Affects Market Participants The change in total welfare includes:
The change in consumer surplus,
The change in producer surplus, and
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 deadweightloss.
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Deadweight Losses and the Gains fromTrade Taxes cause deadweight losses because they
prevent buyers and sellers from realizing some
of the gains from trade.
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Figure 4 The Deadweight Loss
Copyright 2004 South-Western
Cost to
sellersValue to
buyers
Size of tax
Quantity0
Price
Demand
SupplyLost gains
from trade
Reduction in quantity due to the tax
Pricewithout tax
Q1
PB
Q2
PS
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DETERMINANTS OF THEDEADWEIGHT LOSS
What determines whether the deadweight lossfrom a tax is large or small?
The magnitude of the deadweight loss depends on
how much the quantity supplied and quantitydemanded respond to changes in the price.
That, in turn, depends on the price elasticities of
supply and demand.
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Figure 5 Tax Distortions and Elasticities
Copyright 2004 South-Western
(a) Inelastic Supply
Price
0 Quantity
Demand
Supply
Size of tax
When supply isrelatively inelastic,
the deadweight loss
of a tax is small.
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Figure 5 Tax Distortions and Elasticities
Copyright 2004 South-Western
(b) Elastic Supply
Price
0 Quantity
Demand
SupplySize
of
tax
When supply is relatively
elastic, the deadweight
loss of a tax is large.
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Figure 5 Tax Distortions and Elasticities
Copyright 2004 South-Western
Demand
Supply
(c) Inelastic Demand
Price
0 Quantity
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
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Figure 5 Tax Distortions and Elasticities
Copyright 2004 South-Western
(d) Elastic Demand
Price
0 Quantity
Size
of
tax Demand
Supply
When demand is relatively
elastic, the deadweight
loss of a tax is large.
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DETERMINANTS OF THEDEADWEIGHT LOSS
The greater the elasticities of demand andsupply:
the larger will be the decline in equilibrium
quantity and, the greater the deadweight loss of a tax.
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DEADWEIGHT LOSS AND TAXREVENUE 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.e., those
engaging in illegal activity)
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DEADWEIGHT LOSS AND TAXREVENUE AS TAXES VARY
With each increase in the tax rate, thedeadweight loss of the tax rises even more
rapidly than the size of the tax.
Figure 6 Deadweight Loss and Tax Revenue from Three
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Figure 6 Deadweight Loss and Tax Revenue from ThreeTaxes of Different Sizes
Copyright 2004 South-Western
Tax revenue
Demand
Supply
Quantity0
Price
Q1
(a) Small Tax
Deadweight
lossPB
Q2
PS
Figure 6 Deadweight Loss and Tax Revenue from Three
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Figure 6 Deadweight Loss and Tax Revenue from ThreeTaxes of Different Sizes
Copyright 2004 South-Western
Tax revenue
Quantity0
Price
(b) Medium Tax
PB
Q2
PS
Supply
Demand
Q1
Deadweight
loss
Figure 6 Deadweight Loss and Tax Revenue from Three
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Figure 6 Deadweight Loss and Tax Revenue from ThreeTaxes of Different Sizes
Copyright 2004 South-Western
Tax
revenue
Demand
Supply
Quantity0
Price
Q1
(c) Large Tax
PB
Q2
PS
Deadweight
loss
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DEADWEIGHT LOSS AND TAXREVENUE AS TAXES VARY
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.
Figure 7 How Deadweight Loss and Tax Revenue Vary
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Figure 7 How Deadweight Loss and Tax Revenue Varywith the Size of a Tax
Copyright 2004 South-Western
(a) Deadweight Loss
Deadweight
Loss
0 Tax Size
Figure 7 How Deadweight Loss and Tax Revenue Vary
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Figure 7 How Deadweight Loss and Tax Revenue Varywith the Size of a Tax
Copyright 2004 South-Western
(b) Revenue (the Laffer curve)Tax
Revenue
0 Tax Size
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Copyright 2004 South-Western/Thomson Learning
DEADWEIGHT LOSS AND TAXREVENUE AS TAXES VARY
As the size of a tax increases, its deadweightloss quickly gets larger.
By contrast, tax revenue first rises with the size
of a tax, but then, as the tax gets larger, themarket shrinks so much that tax revenue starts
to fall.
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Copyright 2004 South-Western/Thomson Learning
CASE STUDY: The Laffer Curve and Supply-side Economics
TheLaffer curve depicts the relationshipbetween tax rates and tax revenue.
Supply-side economics refers to the views of
Reagan and Laffer who proposed that a tax cutwould induce more people to work and thereby
have the potential to increase tax revenues.
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Copyright 2004 South-Western/Thomson Learning
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. The fall in total surplusthe sum of consumer
surplus, producer surplus, and tax revenue is
called the deadweight loss of the tax.
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Copyright 2004 South-Western/Thomson Learning
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 themarket below the level that maximizes total
surplus.
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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.
