Chapter 8 The Costs of Taxation. Objectives 1. Understand how taxes reduce consumer and producer...
57
Chapter 8 The Costs of Taxation
Transcript of Chapter 8 The Costs of Taxation. Objectives 1. Understand how taxes reduce consumer and producer...
Chapter 8
The Costs of Taxation
Objectives
1. Understand how taxes reduceconsumer and producer surplus
2. Learn the causes and significanceof the deadweight loss of a tax
3. Know why some taxes have larger deadweight losses than others
4. Understand the relationship among deadweight loss, tax revenue, and thesize of a tax
The Costs of Taxation
How does the application of a tax affect the market
system?Review Chapter 6 & 7!
The Costs 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.
Market Efficiency: Three observations
Free markets allocate the supply of goods to the buyers who value them most highly.
Free markets allocate the demand for goods to the sellers who can produce them at least cost.
Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.
Consumer Surplus: Verbal Definition
The amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it.
D
Producer Surplus: Verbal Definition
The amount a seller is paid minus the
cost of production.
Producer surplus measures the
benefit to sellers of participating in a
market.
S
Market Efficiency
Under the assumptions of perfect competition, no externalities, and no taxes the economic well-being of a society is measured as the sum of consumer surplus and producer surplus.
Market Efficiency is attained when total surplus is maximized, a point where resource allocation is efficient.
Market Efficiency
S
D
PE
ConsumerSurplus
ProducerSurplus
Taxes! Taxes! Taxes!
Who pays the tax on a good? The buyer or the seller?
How is the burden of a tax divided between buyer and seller?
When the government levies a tax on a good, the equilibrium quantity of the good falls. The size of the market for
that good shrinks.
The Costs of Taxation A tax places a wedge
between the price buyers pay and the price sellers receive.
Tax!
The Costs of Taxation A tax places a wedge
between the price buyers pay and the price sellers receive.
A tax results in a Deadweight Loss to society and the economy
Tax! Loss!
How a Tax Affects Welfare...
Quantity0
Price
Demand
Supply
Q1
A
BC
F
D E
Q2
Tax reduces consumer surplus by (B+C) and producer surplus by (D+E)
Tax revenue = (B+D)
Deadweight Loss = (C+E)
Price buyerspay = PB
P1
Price without tax
=
PSPrice sellers receive
=
Changes in Welfare from a Tax
Without Tax With Tax Change
Consumer Surplus A + B + C A - (B + C)
Producer Surplus D + E + F F - (D + E)
Tax Revenue none B + D + (B + D)
Total Surplus A + B + C + D + E + F
A + B + D + F - (C + E )
The area C+E shows the fall in total surplus and is the deadweight loss of the tax.
How a Tax Affects Welfare
The change in total welfare includes: The change in consumer surplus, The change in producer surplus, 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 deadweight loss.
Tax Revenue
T = the size of the tax
Q = the quantity of the good sold
TQ = the government’s tax revenue
Tax Revenue...Price
0 QuantityQuantity without tax
Supply
Demand
Price sellers
receive
Quantity with tax
Size of tax (T)
Quantity sold (Q)
Tax Revenue (T x Q)
Price buyers
pay
Deadweight Loss
Deadweight Loss is the reduction in total surplus
that results from a tax
Deadweight Loss of Taxation When a tax is levied on buyers, the
demand curve shifts downward bythe size of the tax.
When a tax is levied on sellers, the supply curve shifts upward by that amount.
The losses to buyers and sellers exceed the tax revenue, leading toa Deadweight Loss.
Deadweight Loss of Taxation: Example
The current market situation of $0.50 per unit of a product results in 1,000 units being offered for sale and purchased.
A twenty cent tax ($0.20) is imposed on the suppliers. Sellers “collect” the tax and send the tax revenue to the government.
Deadweight Loss of Taxation: Graphical
$.50
1000
Demand
Supply
Deadweight Loss of Taxation: Graphical
$.50
1000
Demand
Supply
$.60
$.40
800
$.20 tax imposed
Deadweight Loss of Taxation: Example
The twenty cent tax results in new prices to consumers and producers:
– Consumers pay $0.60
– Sellers receive $0.40
The Tax Revenue from the imposed tax is = $160
i.e. [($0.60-$0.40) x 800]
Deadweight Loss of Taxation: Graphical
$.50
1000
Demand
Supply
$.60
$.40
800
Tax Revenue
Tax Revenue
T = the size of the tax
Q = the quantity of the good sold
TQ = the government’s tax revenue
Deadweight Loss of Taxation
The tax places a wedge between the price buyers pay and the price seller receive. The higher price to buyers and the lower price to sellers resultsin a lower quantity demanded and quantity supplied.
The loss in quantity demanded and the quantity supplied is 200 units (1000 - 800).
Deadweight Loss of Taxation: Graphical
$.50
1000
Demand
Supply
$.60
$.40
800
Loss inQuantity
Deadweight Loss of Taxation: Graphical
$.50
1000
Demand
Supply
$.60
$.40
800
DeadweightLoss!
Deadweight Loss of Taxation, example
The deadweight loss of 200 units do no one any good
– The value of the loss to society due to the twenty cent tax is = $20 ($500 - $480)
Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.
The Deadweight Loss
{Size ofTax
Supply
Demand
Quantity
Price
0
Cost tosellers
Cost tobuyers
}Lost gainsfrom trade
Pricew/o tax
Reduction in quantity due to the tax
Q2 Q1
PS
PB
Determinants of Deadweight Loss
The magnitude of the Deadweight Loss depends upon how large a decline in market exchange occurs as a result of the tax.
The size in the decline in market exchange depends upon how sensitive consumers and producers are to changes in prices: Elasticity Concept.
How a Tax Affects Welfare
Q
Demand
SupplyPrice buyers
pay
0
Price without tax
Priceseller
receive
2 Q1
Ps
P1
PB
Price
A
B
D
F
How a Tax Affects Welfare
Q
Demand
SupplyPrice buyers
pay
0
Price without tax
Priceseller
receives
2 Q1
Ps
P1
PB
Price
A
B
D
F
C
E
Changes in Welfare From a Tax
Consumer surplusConsumer surplus
Producer surplusProducer surplus
Tax revenueTax revenue
Total surplusTotal surplus
Consumer surplusConsumer surplus
Producer surplusProducer surplus
Tax revenueTax revenue
Total surplusTotal surplus
Without Tax WithTax Change
A+B+CA+B+C
D+E+FD+E+F
NoneNone
A+B+C+D+E+FA+B+C+D+E+F
A+B+CA+B+C
D+E+FD+E+F
NoneNone
A+B+C+D+E+FA+B+C+D+E+F
AA
FF
B+DB+D
A+B+D+FA+B+D+F
AA
FF
B+DB+D
A+B+D+FA+B+D+F
- (B+C)- (B+C)
- (D+E)- (D+E)
+ (B+D)+ (B+D)
- (C+E)- (C+E)
- (B+C)- (B+C)
- (D+E)- (D+E)
+ (B+D)+ (B+D)
- (C+E)- (C+E)
Changes in Welfare From a Tax
00
$.20$.20
$.40$.40
$.60$.60
$.80$.80
$1.00$1.00
00
$.20$.20
$.40$.40
$.60$.60
$.80$.80
$1.00$1.00
Tax(cents/roll)
ConsumerPay
SellersReceive
QuantityExchanged
Tax Revenue
DeadweightLoss
$.50$.50
$.60$.60
$.70$.70
$.80$.80
$.90$.90
00
$.50$.50
$.60$.60
$.70$.70
$.80$.80
$.90$.90
00
$.50$.50
$.40$.40
$.30$.30
$.20$.20
$.10$.10
00
$.50$.50
$.40$.40
$.30$.30
$.20$.20
$.10$.10
00
10001000
800800
600600
400400
200200
00
10001000
800800
600600
400400
200200
00
00
$160$160
$240$240
$240$240
$160$160
00
00
$160$160
$240$240
$240$240
$160$160
00
00
$20$20
$80$80
$180$180
$320$320
$500$500
00
$20$20
$80$80
$180$180
$320$320
$500$500
Determinants of Deadweight Loss
The more elastic demand and supply are, the greater will be the
decline in equilibrium quantity and the greater the
Deadweight Loss.
Tax Distortions and Elasticitiesa) Inelastic Supply
When supply is relatively inelastic, the deadweight loss of a tax is small.
{Size ofTax
Quantity
Price Supply
Demand
0
Tax Distortions and Elasticitiesb) Elastic Supply
When supply is relatively inelastic, the deadweight loss of a tax is large.
{Size ofTax
Supply
Demand
Quantity
Price
0
Tax Distortions and Elasticities...
Quantity
Price
Demand
Supply
0
When demand isrelatively inelastic,the deadweight loss of a tax is small.
(c) Inelastic Demand
Size of
tax
Tax Distortions and Elasticitiesd) Elastic Demand
When demand is relatively inelastic, the deadweight loss of a tax is large.
{Size ofTax
Supply
Demand
Quantity
Price
0
Determinants of Deadweight Loss A tax has a deadweight loss because it
induces buyers and sellers to change their behavior.
– Higher prices cause buyers to buy less.
– Lower prices received causes sellers to offer less.
The size of the market shrinks below the optimum. (Figure 8-6)
The Deadweight Loss Debate
Some economists argue that labor taxes are highly
distorting and believe that labor supply is more elastic.
The Deadweight Loss Debate
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)
Deadweight Loss and Tax Revenue as Taxes Vary
With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size
of the tax.
Tax Revenue
Deadweight Loss and Tax Revenuea) Small Tax
0
PS
PB
Q2 Q1
DeadweightLoss
Supply
Demand
Price
Quantity
Tax Revenue
Deadweight Loss and Tax Revenuea) Medium Tax
0
PS
PB
Q2 Q1
DeadweightLoss
Supply
Demand
Price
Quantity
Tax
Rev
enu
e
Deadweight Loss and Tax Revenuea) Large Tax
0
PS
PB
Q2 Q1
DeadweightLoss
Supply
Demand
Price
Quantity
Less Elastic Demand and Supply
S0
D0
QE
PE
S2
P2
Q2
Amount of Tax
Less Elastic Demand and Supply
S0
D0
QE
PE
S2
P2
Q2
Amount of Tax
DeadweightLoss!
Deadweight Loss and Tax Revenue
The deadweight loss of a tax rises even more rapidly than the size of the tax.
– It is related to the area of a triangle. If we double the tax, the size of the triangle increases four times.
With each increase in the tax rate, tax revenues will rise slowly, reach a maximum, and decline.
The Costs of Taxation: Conclusion
When a tax is imposed on a good, the tax reduces consumer and producer surplus by an amount that is greater than the tax revenue generated.
The difference between the decrease in total consumer and producer surplus and the tax revenue generated is referred to as the Deadweight Loss of a tax.
With the increase in the tax rate, the percentage decrease in market equilibrium quantity becomes greater. Tax revenues begin to decrease.
As the tax gets larger, the deadweight loss increases more proportionate than the tax increase.
The Costs of Taxation: Conclusion
Changes in Welfare From a Tax
00
$.20$.20
$.40$.40
$.60$.60
$.80$.80
$1.00$1.00
00
$.20$.20
$.40$.40
$.60$.60
$.80$.80
$1.00$1.00
Tax(cents/roll)
ConsumerPay
SellersReceive
QuantityExchanged
Tax Revenue
DeadweightLoss
$.50$.50
$.60$.60
$.70$.70
$.80$.80
$.90$.90
00
$.50$.50
$.60$.60
$.70$.70
$.80$.80
$.90$.90
00
$.50$.50
$.40$.40
$.30$.30
$.20$.20
$.10$.10
00
$.50$.50
$.40$.40
$.30$.30
$.20$.20
$.10$.10
00
10001000
800800
600600
400400
200200
00
10001000
800800
600600
400400
200200
00
00
$160$160
$240$240
$240$240
$160$160
00
00
$160$160
$240$240
$240$240
$160$160
00
00
$20$20
$80$80
$180$180
$320$320
$500$500
00
$20$20
$80$80
$180$180
$320$320
$500$500
Deadweight Loss and Tax Revenue Vary with the Size of the Tax...
(a) Deadweight LossDeadweight
Loss
0Tax Size
Deadweight Loss and Tax Revenue Vary with the Size of the Tax...
(b) Revenue (the Laffer curve)Tax
Revenue
0 Tax Size
The Laffer Curve and Supply-Side 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.
2. When taxes are imposed, however, markets loose some of their efficiency. Taxes alter incentivesand distort market outcomes
1. Since we all expect government to provide certain services such as roads, police and national defense,it is necessary to raise revenue.
Conclusion
