principles of micro chapter 8: “application: the cost of taxation” by tanya molodtsova, fall...
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Principles of MicroPrinciples of Micro
Chapter 8: “Application: The Cost of Chapter 8: “Application: The Cost of Taxation”Taxation”
by Tanya Molodtsova, Fall 2005
We Will Learn:We Will Learn:
taxes reduce consumer and taxes reduce consumer and producer surplus producer surplus
the meaning and causes of the the meaning and causes of the deadweight loss from a tax deadweight loss from a tax
why some taxes have larger why some taxes have larger deadweight losses than others deadweight losses than others
how tax revenue and how tax revenue and deadweight loss vary with the deadweight loss vary with the size of a tax size of a tax
The Deadweight Loss of The Deadweight Loss of Taxation Taxation
Buyers and sellers receive Buyers and sellers receive benefits from taking part in the benefits from taking part in the market. market.
The total welfare of buyers and The total welfare of buyers and sellers is maximized in equilibriumsellers is maximized in equilibrium
How do taxes affect the economic How do taxes affect the economic well-being of market participants?well-being of market participants?
The Deadweight Loss of The Deadweight Loss of TaxationTaxation
It does not matter whether a tax It does not matter whether a tax on a good is levied on buyers or on a good is levied on buyers or sellers of the good . . . the price sellers of the good . . . the price paid by buyers rises, and paid by buyers rises, and the price received by sellers falls.the price received by sellers falls.
The Effect of a TaxThe Effect of a Tax
Size of tax
Quantity0
Price
Price buyerspay
Price sellersreceive
Demand
Supply
Pricewithout tax
Quantitywithout tax
Quantitywith tax
How a Tax Affects Market How a Tax Affects Market ParticipantsParticipants
A tax places a A tax places a wedgewedge between between the price buyers pay and the the price buyers pay and the price sellers receive. price sellers receive.
the quantity sold falls below the the quantity sold falls below the level that would be sold without level that would be sold without a tax.a tax.
The size of the market for that The size of the market for that good shrinksgood shrinks
How a Tax Affects Market How a Tax Affects Market ParticipantsParticipants
Tax RevenueTax Revenue TT = the size of the tax = the size of the tax QQ = the quantity of the good sold = the quantity of the good sold
TT QQ = the government’s = the government’s
tax revenuetax revenue
Tax RevenueTax Revenue
Taxrevenue
(T × Q)
Size of tax (T)
Quantitysold (Q)
Quantity0
Price
Demand
Supply
Quantitywithout tax
Quantitywith tax
Price buyerspay
Price sellersreceive
How a Tax Affects Welfare How a Tax Affects Welfare
A
F
B
D
C
E
Quantity0
Price
Demand
Supply
= PB
Q2
= PS
Pricebuyers
pay
Pricesellersreceive
= P1
Q1
Pricewithout tax
How a Tax Affects WelfareHow a Tax Affects Welfare
Welfare Before a Tax: Welfare Before a Tax:
Consumer surplus = A + B + C.Consumer surplus = A + B + C.
Producer surplus = D + E + F.Producer surplus = D + E + F.
Total surplus = A+ B+ C+ D+ E+F.Total surplus = A+ B+ C+ D+ E+F. Welfare After Tax:Welfare After Tax:
Consumer surplus = A.Consumer surplus = A.
Producer surplus = F.Producer surplus = F.
Tax revenue = B + D.Tax revenue = B + D.
Total surplus = A + B + D + F. Total surplus = A + B + D + F.
How a Tax Affects WelfareHow a Tax Affects Welfare
Total surplus decreases by C+ETotal surplus decreases by C+E deadweight lossdeadweight loss: the fall in : the fall in
total surplus that results from total surplus that results from a market distortion, such as a a market distortion, such as a tax.tax.
How a Tax Affects WelfareHow a Tax Affects Welfare
The change in total welfare The change in total welfare includes:includes:
The change in consumer surplus,The change in consumer surplus, The change in producer surplus, The change in producer surplus,
andand The change in tax revenue.The change in tax revenue. The losses to buyers and sellers The losses to buyers and sellers
exceed the revenue raised by the exceed the revenue raised by the government.government.
This fall in total surplus is called the This fall in total surplus is called the deadweight loss.deadweight loss.
Deadweight Losses and the Deadweight Losses and the Gains from Trade Gains from Trade
Taxes cause deadweight Taxes cause deadweight losses because they prevent losses because they prevent buyers and sellers from buyers and sellers from realizing some of the gains realizing some of the gains from trade.from trade.
The Deadweight LossThe Deadweight Loss
Cost tosellersValue to
buyers
Size of tax
Quantity0
Demand
SupplyLost gainsfrom trade
Reduction in quantity due to the tax
Pricewithout tax
Q1
PB
Q2
PS
The Determinants of the The Determinants of the Deadweight Loss Deadweight Loss
The magnitude of the The magnitude of the deadweight loss depends on deadweight loss depends on how much the quantity supplied how much the quantity supplied and quantity demanded respond and quantity demanded respond to changes in the price.to changes in the price.
That, in turn, depends on the That, in turn, depends on the price elasticities of supply and price elasticities of supply and demand.demand.
Tax Distortions and ElasticitiesTax Distortions and Elasticities
Price
0 Quantity
Demand
Supply
Size of tax
When supply isrelatively inelastic,the deadweight lossof a tax is small.
(a) Inelastic Supply
Tax Distortions and Tax Distortions and ElasticitiesElasticities
(b) Elastic Supply
Price
0 Quantity
Demand
SupplySizeoftax
When supply is relativelyelastic, the deadweightloss of a tax is large.
Tax Distortions and Tax Distortions and ElasticitiesElasticities
Demand
Supply
(c) Inelastic Demand
Price
0 Quantity
Size of taxWhen demand isrelatively inelastic,the deadweight lossof a tax is small.
Tax Distortions and Tax Distortions and ElasticitiesElasticities
(d) Elastic Demand
Price
0 Quantity
Sizeoftax Demand
Supply
When demand is relativelyelastic, the deadweightloss of a tax is large.
The Determinants of the The Determinants of the Deadweight LossDeadweight Loss
The greater the elasticities of The greater the elasticities of demand and supply:demand and supply:
the larger will be the decline in the larger will be the decline in quantity sold and,quantity sold and,
the greater the deadweight the greater the deadweight loss of a tax.loss of a tax.
Case Study: The Deadweight Case Study: The Deadweight Loss DebateLoss Debate
Some economists argue that labor Some economists argue that labor taxes are highly distorting and taxes are highly distorting and believe that labor supply is elastic.believe that labor supply is elastic.
Some examples of workers who Some examples of workers who may respond more to incentives:may respond more to incentives:
Workers who can adjust the number of Workers who can adjust the number of hours they workhours they work
Families with second earnersFamilies with second earners Elderly who can choose when to retireElderly who can choose when to retire Workers in the underground economy Workers in the underground economy
(i.e., those engaging in illegal activity)(i.e., those engaging in illegal activity)
Deadweight Loss and Tax Deadweight Loss and Tax Revenue as Taxes Vary Revenue as Taxes Vary
As taxes increase, the deadweight As taxes increase, the deadweight loss from the tax increases. loss from the tax increases.
In fact, as taxes increase, the In fact, as taxes increase, the deadweight loss rises more quickly deadweight loss rises more quickly than the size of the tax. than the size of the tax.
1.1. The deadweight loss is the area of a The deadweight loss is the area of a triangle.triangle.
2.2. If we double the size of a tax, the base If we double the size of a tax, the base and height of the triangle both double and height of the triangle both double so the area of the triangle (the so the area of the triangle (the deadweight loss) rises by a factor of deadweight loss) rises by a factor of four.four.
Deadweight Loss and Tax Deadweight Loss and Tax Revenue as Taxes VaryRevenue as Taxes Vary
Tax revenue
Demand
Supply
Quantity0
Price
Q1
(a) Small Tax
Deadweightloss
PB
Q2
PS
Deadweight Loss and Tax Deadweight Loss and Tax Revenue as Taxes VaryRevenue as Taxes Vary
Tax revenue
Quantity0
Price
(b) Medium Tax
PB
Q2
PS
Supply
Demand
Q1
Deadweightloss
Deadweight Loss and Tax Deadweight Loss and Tax Revenue as Taxes VaryRevenue as Taxes Vary
Tax
rev
enue
Demand
Supply
Quantity0
Price
Q1
PB
Q2
PS
Deadweightloss
(c) Large Tax
Deadweight Loss and Tax Deadweight Loss and Tax Revenue as Taxes VaryRevenue as Taxes Vary
For the small tax, tax revenue is For the small tax, tax revenue is small.small.
As the size of the tax rises, tax As the size of the tax rises, tax revenue grows.revenue grows.
But as the size of the tax But as the size of the tax continues to rise, tax revenue continues to rise, tax revenue falls because the higher tax falls because the higher tax reduces the size of the market.reduces the size of the market.
Deadweight Loss and Tax Deadweight Loss and Tax Revenue as Taxes VaryRevenue as Taxes Vary
(a) Deadweight Loss
DeadweightLoss
0 Tax Size
Deadweight Loss and Tax Deadweight Loss and Tax Revenue as Taxes VaryRevenue as Taxes Vary
(b) Revenue (the Laffer curve)
TaxRevenue
0 Tax Size
Deadweight Loss and Tax Deadweight Loss and Tax Revenue as Taxes VaryRevenue as Taxes Vary
As the size of a tax increases, As the size of a tax increases, its deadweight loss quickly gets its deadweight loss quickly gets larger.larger.
By contrast, tax revenue first By contrast, tax revenue first rises with the size of a tax, but rises with the size of a tax, but then, as the tax gets larger, the then, as the tax gets larger, the market shrinks so much that tax market shrinks so much that tax revenue starts to fall.revenue starts to fall.
Case Study: Case Study: The Laffer Curve The Laffer Curve and Supply-Side Economicsand Supply-Side Economics
The The Laffer curveLaffer curve depicts the depicts the relationship between tax rates relationship between tax rates and tax revenue.and tax revenue.
Supply-side economicsSupply-side economics refers to refers to the views of Reagan and Laffer the views of Reagan and Laffer who proposed that a tax cut who proposed that a tax cut would induce more people to would induce more people to work and thereby have the work and thereby have the potential to increase tax potential to increase tax revenuesrevenues
SummarySummary A tax on a good reduces the A tax on a good reduces the
welfare of buyers and sellers of the welfare of buyers and sellers of the good, and the reduction in good, and the reduction in consumer and producer surplus consumer and producer surplus usually exceeds the revenues usually exceeds the revenues raised by the government.raised by the government.
The fall in total surplus—the sum The fall in total surplus—the sum of consumer surplus, producer of consumer surplus, producer surplus, and tax revenue — is surplus, and tax revenue — is called the deadweight loss of the called the deadweight loss of the tax.tax.
SummarySummary
Taxes have a deadweight loss Taxes have a deadweight loss because they cause buyers to because they cause buyers to consume less and sellers to consume less and sellers to produce less.produce less.
This change in behavior shrinks the This change in behavior shrinks the size of the market below the level size of the market below the level that maximizes total surplus.that maximizes total surplus.
SummarySummary
As a tax grows larger, it distorts As a tax grows larger, it distorts incentives more, and its incentives more, and its deadweight loss grows larger.deadweight loss grows larger.
Tax revenue first rises with the Tax revenue first rises with the size of a tax.size of a tax.
Eventually, however, a larger tax Eventually, however, a larger tax reduces tax revenue because it reduces tax revenue because it reduces the size of the market.reduces the size of the market.