Chapter 8: Application: The Costs of Taxation

Summary

1) A tax on a good reduces the welfare of buyers and sellers of the good, and the reduction of the consumer and producer surplus usually exceeds the revenue raised by the government. The fall in total surplus- the sum of consumer surplus, producer surplus, and tax revenue- is called the deadweight loss of the tax. 2) Taxes have deadweight losses because they cause buyers to consume less and sellers to produce less, and these changes in behavior shrink the size of the market below the level that maximizes total surplus. Because the elasticities of supply and demand measure how much market participants respond to market conditions, larger elasticities imply larger deadweight losses. 3) As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. Because a tax reduces the size of the market, however, tax revenue does not continually increase. It first rises with the size of the tax, but if the tax gets large enough, tax revenue starts to fall.

How a Tax Affects Market Participants

1) Welfare without a Tax- Without a tax, the equilibrium price and quantity are found at the intersection of the supply and demand curves 2) Welfare with a Tax (Fig. 3)- A tax on a good reduces consumer surplus and producer surplus. Because the fall in producer and consumer surplus exceeds tax revenue, the tax is said to impose a deadweight loss

The Effects of a Tax

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

Total Tax Revenue

If T is the size of the tax and Q is the quantity of the good sold, then the government gets total tax revenue of T*Q. The Government's tax revenue is represented by the rectangle between the supply and demand curves. The height of the rectangle is the size of the tax, T, and the width of the rectangle is the quantity of the good sold, Q. Because a rectangle's area is its height times its width, this rectangle's area is T*Q, which equals the tax revenue

What determines whether the deadweight loss from a tax is large or small?

Price elasticities of supply and demand, which measure how much the quantity supplied and quantity demanded respond to changes in the price. The greater the elasticities of supply and demand, the greater the deadweight loss of a tax

Laffer Curve/Supply-Side Economics

Tax revenue first rises and then falls- if you tax people at an extreme level it will actually discourage hard work. Laffer argued that lowering taxes would give people the proper incentive to work, which would raise economic well-being and perhaps even tax revenue

Ultimate Source of Deadweight Losses

Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade

How Deadweight Loss and Tax Revenue Vary with the Size of a Tax

The deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the amount of the tax times the amount of the good sold. A small tax has a small deadweight loss and raises a small amount of revenue A medium tax has a larger deadweight loss and raises a larger amount of revenue 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

Changes in Welfare

The losses to buyers and sellers from a tax exceed the revenue raised by the government. The fall in total surplus that results when a tax distorts a market outcome is called a deadweight loss. Since taxes distort incentives, they cause markets to allocate resources inefficiently

Tax Distortions and Elasticities (Fig 5)

When demand or supply is relatively inelastic, the deadweight loss of a tax is small When demand or supply is relatively elastic, the deadweight loss of a tax is large

What happens to the deadweight loss as the size of the tax grows larger?

the deadweight loss grows larger

Deadweight Loss

the fall in total surplus that results from a market distortion, such as a tax