LECTURE #7: MICROECONOMICSCHAPTER 8

Economic Costs of Taxation

Deadweight Loss and Social Policy

The Deadweight Loss of Taxation

Taxes (Sales, Use or Excise)Levied on buyers

Demand curve shifts downward by the size of tax

Levied on sellersSupply curve shifts upward by the size of tax

Same outcome: price wedgePrice paid by buyers – rises

Price received by sellers – falls

Lower quantity sold

2

The Effects of a Tax

3

Price

Quantity0

Demand

SupplyPrice buyers pay

Price without tax

Price sellers receive

Sizeof tax

Figure 1: A tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls.

Quantitywith tax

Quantitywithout tax

The Deadweight Loss of Taxation

Tax BurdenDistributed between producers and consumers

Determined by elasticities of S & D Market for the good – smaller

Taxes and Deadweight LossesWelfare losses to buyers and sellers exceed tax

revenues to government

Deadweight Loss = fall in total surplus

Taxes prevent buyers and seller from realizing gains from trade

4

Economic Costs of Taxation

Tax Revenue = Amount of tax (T) times Quantity (Q) (See Fig 2)Recall: Taxes raise the price paid and reduce the prices

received.

Taxes effectively reduce consumption.Reduced consumption = reduced standard of living

Reduced consumption leads to increased in unemployment

Some proportion of the producer/consumer surpluses discussed in Chapter 7 effectively expropriated via taxes. Compare Figure 7, Ch 7 and Figure 3, Ch 8

Tax Revenue

6

Price

Quantity0

Demand

Supply

Figure 2: The tax revenue that the government collects equals T × Q, the size of the tax T times the quantity sold Q.

Quantitywith tax

Quantitywithout tax

Size of tax (T)

Quantity sold (Q)

Taxrevenue

T ˣ Q

Price buyers pay

Price sellers receive

Taxes and Deadweight LossesFigure 3

7

Price

Quantity0

Demand

SupplyA tax on a good reduces consumer surplus (by the area B + C) and producer surplus (by the area D + E). Because the fall in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a deadweight loss (area C + E).

A

B

D

F

Q1

C

E

Pricesellersreceive

=PS

Pricewithout

tax

=P1

Pricebuyers

pay =PB

Q2

Without Tax With Tax Change

Consumer SurplusProducer SurplusTax RevenueTotal Surplus

A+B+CD+E+FNone

A+B+C+D+E+F

AF

B+DA+B+D+F

-(B+C)-(D+E)+(B+D)-(C+E)

The area C + E shows the deadweight loss resulting from the tax

Determinants of the Deadweight Loss

Price Elasticities of Supply and DemandIf PED or SED more elastic – deadweight losses are

larger

If either is inelastic, deadweight losses are smaller

Tax Distortions and Elasticities of Supply

9

Price

Quantity0

(a) Inelastic supply

Figure 5: In panels (a) and (b), the demand curve and the size of the tax are the same, but the price elasticity of supply is different. The more elastic the supply curve, the larger the deadweight loss of the tax.

(b) Elastic supply

Sizeof tax

When supply is relatively inelastic, the deadweight loss of a tax is small

Price

Quantity0

Sizeof tax

When supply is relatively elastic, the deadweight loss of a tax is large

Demand

Supply

Demand

Supply

Tax Distortions and Elasticities of Demand

10

Price

Quantity0

(c) Inelastic demand

Figure 5: In panels (c) and (d), the supply curve and the size of the tax are the same, but the price elasticity of demand is different. The more elastic the demand curve, the larger the deadweight loss of the tax.

(d) Elastic demand

Sizeof tax

Demand

Supply

When demand is relatively inelastic, the deadweight loss of a tax is small

Price

Quantity0

Sizeof tax

Demand

Supply

When demand is relatively elastic, the deadweight loss of a tax is large

Break Time

Deadweight Loss and Social Policy

The larger the deadweight loss, the more expensive social programs

The greater the elasticity of supply and demand, the greater the deadweight loss

The Economic Argument: The impact of labor taxesIf the labor supply is relatively inelastic – then the

deadweight losses are smaller.If the labor supply is relatively elastic – then the deadweight

losses are larger.Regardless: the larger the tax, the greater the deadweight

losses (See Fig 6)

Deadweight Loss and Social Policy

Arguments for Elastic Labor SupplyOver-time premiums

Second or third income net take-home pay

Incentives for part time work

Incentives to work "under the table"

Laffer Curve and Supply-Side EconomicsReducing taxes eventually causes revenues to rise

High tax rates discourage working, consumption, and investing

Lowering tax rates encouraged consumption and employment

Deadweight Loss, Magnitude of Tax and Tax Revenue

Figure 6

14

Price

Quantity

0

(a) Small tax

Panel (a), a small tax has a small deadweight loss and raises a small amount of revenue.Panel (b), a larger tax has a larger deadweight loss and raises a larger amount of revenue. Panel (c), a very large tax has a very large deadweight loss, but because it has reduced the size of the market so much, the tax raises only a small amount of revenue.

Demand

Supply

Deadweightloss

Q1

PB

PS

Q2

Taxrevenue

Price

Quantity

0

(b) Medium tax

Demand

Supply

Deadweightloss

Q1

PB

PS

Q2

Taxrevenue

Price

Quantity

0

(c) Large tax

Demand

Supply

Deadweightloss

Q1

PB

PS

Q2

Tax

rev

enue

Deadweight Loss, Magnitude of Tax and Tax Revenue

15

Deadweightloss

Tax size0

(d) From panel (a) to panel (c),deadweight loss continually increases

Panels (d) and (e) summarize these conclusions. Panel (d) shows that as the size of a tax grows larger, the deadweight loss grows larger. Panel (e) shows that tax revenue first rises and then falls. This relationship is sometimes called the Laffer curve.

(e) From panel (a) to panel (c), taxrevenue first increases, then decreases

TaxRevenue

Tax size0

Laffer curve

Reagan Revolution

Supply Side Economics (Arthur Laffer)High marginal tax rates discourage workingHigh marginal tax rates discourage investmentResult is decrease in tax revenues → deficits

ReaganomicsReduce Marginal Tax Rates

Encourage workingEncourage investmentIncrease in incomes → increase in tax revenues

Empirical data suggests the greater the marginal rate, the less people work (See “In The News”, page 170)

In The News: On The Way to FranceWSJ, Oct 20,2003

Country Tax Rate (%) Workweek Hrs

Italy 64 16.5

France 59 17.5

Germany 59 19.3

Canada 52 22.8

UK 44 22.9

US 40 25.9

Japan 37 27.0

Homework

Questions for Review: 1, 2, 4

Problems and Applications: 6, 12 (a, b, c, e)

Problems & Applications

#12. Suppose that a market is described by the following supply and demand equations:

QS = 2P

QD = 300 – P

a. Solve for the Equilibrium Price and QuantityRecall that at Equilibrium QS = QD, therefore

2P = 300 – P

3P = 300

P = $100 → QS = 200 and QD = 200 (units)

Problem #12 Continued

b. Suppose that a tax of T is placed on buyers. The new demand equation is:

QD = 300 – (P + T)

What is the new Equilibrium?

QS = 2P

2P = 300 – (P + T)

P = 100 – T/3 (price received by seller)

P = 100 - T/3 + T = 100 + 2T/3 (price paid by buyer)

Problem #12 Continued

b.1. Suppose Tax = $15Producer Receives (PT) = $100 – 5 = $95

Quantity Supplied = 2 (95) = 190

Consumer Pays = P + T = $95 + $15 = $110

New QD = 300 – (S + T) = 300 – 110 = 190

New QS = 2S = 2 * 95 = 190

c. Deadweight Loss = T * Q = $15 * 190 = $2,850Revenue [Expense] @ ϵ = 200 * 100 = 20,000

New Producer Revenue = 190 * 95 = $18,050

New Consumer Expenditure = 110 * 190 = 20,900

Difference = $20,900 – 18,050 = $2,850 (QED)

Problem #12 Continued