Week 4

Taxes

Governments levy taxes to raise revenue for public projects.

Tax incidence

Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

The burden of a tax falls...

more heavily on the side of the market that is less elastic.

When supply is more elastic than demand...

the incidence of the tax falls more heavily on consumers

When demand is more elastic than supply ...

the incidence of the tax falls more heavily on producers

the deadweight loss of a tax is large when...

when supply or/and demand is relatively elastic

the deadweight loss of a tax is small when...

when supply or/and demand is relatively inelastic

Tax and Deadweight loss

• As the size of a tax increases, its deadweight loss quickly gets larger. • By contrast, tax revenue first rises with the size of a tax, but then, as the tax gets larger, the market shrinks so much that tax revenue starts to fall.

Tax and tax revenue

• 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.

Deadweight loss of taxation

• How do taxes affect the economic wellbeing of market participants? • 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.

Taxes - market outcomes

• Taxes discourage market activity. • When a good is taxed, the quantity sold is smaller. • Buyers and sellers share the tax burden.

Laffer Curve

• The Laffer Curve depicts the relationship between tax rates and tax revenue.