Chapter 8: The Costs of Taxation

What are examples of tax on labor?

Social Security, federal income tax, medicare tax

How do you calculate the amount of revenue the government gains from imposing tax?

T x Q Size of tax (T) times the quantity sold (Q) On a diagram of the market, the governments revenue is represented by a rectangular region in the middle of the large total surplus triangle.

How does tax affect quantity sold?

Tax decreases the quantity sold (DWL of Tax)

What can we conclude about how taxation affects market efficiency?

Taxation makes the economy less efficient, whereby certain gains from trade are not being realised; consumers and producers are not benefitting the most from trade. Taxes cause inefficiency because a) governments take some of the revenue b) taxes alter incentives and distort market outcomes

Describe welfare without tax.

Without any tax levied on the (free) market, the product is being sold at the equilibrium, meaning that the benefits to consumers and producers are maximized.

What can we say about the market when taxes distort incentives?

The market becomes inefficient. Potential gains from trade are not being realised.

Which region is the consumer surplus without tax?

The right angle triangle shape that is formed beneath the demand curve, before the equilibrium. Calculated by (b*h)/2

Which region is the producer surplus without tax?

The right-angled triangle above the supply curve and before the equilibrium. Calculated by (b*h)/2

Which region is the producer surplus with tax?

The right-angled triangle above the supply curve, not including the losses from the deadweight loss of tax and the government revenue.

Which region is the deadweight loss of tax?

The small isosceles triangle formed between the equilibrium quantity and the decreased, new quantity as a result of the levied tax and the consequently created tax wedge. It can be calculated by (b*h)/2

Which region is the consumer surplus with tax?

The smaller right-angled triangle below the demand curve, this time not including the losses from deadweight loss of tax and the government revenue.

Which region is the tax revenue received by government?

The square region between the consumer and producer surplus that is the height of the tax wedge and has the width of the new (decreased) quantity demanded and supplied. It is calculated by T*Q.

How does tax affect the market other than creating a wedge (a difference) between the price buyers pay and the price sellers receive?

The tax will shrink the size of the market.

Which region is the total surplus with tax?

The total surplus subtracted by the deadweight loss of tax. Alternatively it can be calculated by adding the consumer surplus, the producer surplus and the government revenue.

What is the goal of this chapter?

To examine how taxes affect welfare (the well-being of the constituents—buyers and sellers—in the market)

Why do governments impose tax on markets?

To raise revenue, which may be used for the provision of service, education, police, building of roads, to help the needy.

Tell me about the debate on the tax on labor between economists.

Economists who believe that supply is inelastic argue that labor tax does not really distort the market for labor, and that the deadweight loss of tax is small. Their premise is that supply is inelastic, which they defend by claiming that most inidividuals will choose to work full-time regardless of the wage. Economists who believe that supply is elastic argue that labour tax distorts the market, and the deadweight loss of tax as a result is large. Their premise is that supply is elastic, which they defend by suggesting that individuals who would work overtime would lose the incentive to do so if the deadweight loss of tax was so burdensome.

Describe welfare with tax.

If a tax is imposed on a market, then the quantity demanded and supplied will decrease, and buyers will be now paying a higher price, while suppliers are receiving a lower price. The deadweight loss of tax occurs because the of the decrease in quantity demanded. The government receives tax revenue which is calculated by the tax payed by buyers and sellers (T) multiplied by the quantity sold (Q). The total surplus decreases, and is computed by adding consumer surplus, producer surplus and government revenue (or otherwise the original total surplus subtracted by the deadweight loss of tax).

How does elasticity affect the deadweight loss of tax?

If supply and demand are relatively inelastic (demand and supply don't really respond to a change in price), the DWL of tax is small. If supply and demand are elastic (demand and supply respond greatly to a change in price), the DWL of tax is greater.

What happens to tax revenue as tax size increases?

Initially, raising the tax size will increase government revenue, however this increase exponentially slows down, and eventually, at one point, the increase in tax size will decrease tax revenue. This model is called the "Laffer Curve" (named after Arthur Laffer), also known as suply-side economics. y axis: tax revenue x axis: size of tax the graph would depict a parabola (sad face).

What is the obvious effect of taxation on buyers and sellers?

The burden of tax is distributed between buyers and sellers. Hence, buyers pay a higher price, while sellers receive a lower price. Whether the tax is placed on consumers or suppliers does not affect the market outcomes any differently, the distribution of the burden of tax demands on whether demand or supply is more elastic). If supply is more elastic than demand, then more of the burden of tax is payed by the consumer. If demand is more elastic than supply, then the seller will pay a higher portion of the burden of tax.

What is "deadweight loss of tax"

The deadweight loss (DWL) of tax refers to the amount of total surplus that is lost due to a reduce in quantity because of the tax that is imposed (levied). It is defined as a decrease in total surplus due to a market distortion, such as tax.

What happens to deadweight loss as taxes increase.

The deadweight loss increases at a greater rate (exponentially) than the tax increase. This can be modelled on a graph: y axis: deadweight loss x axis: tax size the graph would then depict an upward sloping, curved, exponential curve. So, when tax is small, increasing it won't cause much damage, and decreasing it won't cause much benefit. But, when tax is already very high, increasing tax is very harmful for economic well-being, decreasing it, will cause much benefit (for consumers, producers, but also governments).

Which region is the total surplus without tax?

The entire (isosceles) triangle below the equilibrium quantity, and between the supply and demand curve. Calculated by CS + PS.