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# Mankiw chp.8

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• This chapter builds very closely on material from the previous three chapters: it uses the tools of welfare economics (from Chapter 7) to analyze the effects of a tax (introduced in Chapter 6). It explores the relationship between the price elasticities of demand and supply (Chapter 5) with the deadweight loss of the tax. Covering this chapter immediately after the previous three will reinforce the concepts students learned in those chapters. The material in chapter 8 is important. The government must raise revenue to pay for the police, the court system, interstate highways, national defense, public education, and so forth. The government must choose which goods to tax and how much to tax each one. Effective tax policy generates the needed revenue while striving for (the sometimes conflicting goals of) efficiency and equity. This is not one of the longer chapters; most instructors cover it in 1.5 or 2 hours of class time. But if you’re pressed for time and looking for things to cut, you might consider cutting some of these (my personal suggestions, not the official recommendations of Greg Mankiw or South-Western/Cengage): Revenue and the size of the tax, the Laffer Curve DWL and the size of the tax Active Learning 3, the slide with the discussion question on whether to tax groceries or meals at fancy restaurants Active Learning 2
• If you wish, you may delete this slide and give the information verbally as you cover the following slide.
• If you wish, you may delete this slide and give the information verbally at the beginning of the next slide.
• In chapter 7, students learned how to compute the area of triangles representing CS, PS, and total surplus. This skill is required to do this exercise. Most students will need a calculator to do part B. Your students need not draw the graph in order to do these calculations. However, if your students are using the gutted student handouts we provide to accompany the Premium PowerPoint presentations, they will have parts of the graph on their handouts. Ask your students to shade the areas corresponding to CS, PS, tax revenue and DWL directly on the printed graphs.
• To compute DWL, simply subtract total surplus with the tax (\$18750) from total surplus without the tax (\$20,000, which was computed on the preceding slide). Equivalently, compute the area of the blue shaded triangle: ½ x (100-75) x (\$250 – \$150) = \$1250 .
• When there’s no tax, the market equilibrium quantity maximizes total surplus. The tax causes the price sellers receive to fall, so sellers will supply a smaller quantity, and the new equilibrium quantity falls below the one that maximizes total surplus – hence the DWL. When supply is inelastic, sellers do not reduce Q much below the surplus-maximizing quantity, so DWL is small.
• In this graph, the demand curve, equilibrium price, and size of the tax are identical to those in the graph on the preceding slide. The only thing that’s different is the supply curve here is flatter; as a result, the same size tax as before causes a larger DWL.
• The tax raises the price buyers pay and therefore reduces the quantity demanded. The equilibrium quantity falls below the surplus-maximizing quantity, but not by much when demand is price-inelastic.
• In this graph, the supply curve, equilibrium price, and size of the tax are identical to those in the graph on the preceding slide. The only thing that’s different is the demand curve here is flatter; as a result, the same size tax as before causes a larger DWL.
• These examples (breakfast cereal vs. sunscreen) were chosen not because they are exciting real-world policy debates, but because they link back to the examples used in Chapter 5 to help students deduce the factors that determine elasticity. Suggestion: Display all three questions and give students a few moments to think about it. Then, proceed to the following slides… It might be worth mentioning the following to students: For each pair of goods, we are considering taxes of similar relative magnitude. E.g., it wouldn’t be fair to ask whether a \$10 per bottle tax on sunscreen has a bigger DWL than a \$0.01 tax on boxes of breakfast cereal.
• Suggestion: Display the first line, then invite students to volunteer their answers before displaying the explanation.
• Engage your students and give them a brief break from lecture. Show this slide and ask for students to volunteer their thoughts. The question on this slide will almost certainly elicit a few different opinions. Of course, there is no single “correct” answer – one choice is not unambiguously better than the other. A tax on groceries would be more efficient (smaller DWL) than a tax on restaurant meals. However, a tax on groceries would hurt people with low incomes proportionately more than people with higher incomes, as the former spend a larger percentage of their income on groceries. Hence, such a tax would be regressive. Once again, we see the tradeoff between efficiency and equity/equality.
• The next few slides are adapted from the section “Case Study: The Deadweight Loss Debate” in this chapter of the textbook. The title of this slide is actually a direct quote from this section. I think it makes a catchier title for these slides than “the deadweight loss debate.” Why the marginal tax rate is relevant: One of the 10 Principles from Chapter 1 is “rational people think at the margin.” This applies to workers, as well. When Susan considers increasing her hours, she takes into account the extra income she’d earn from working a few more hours a week. The extra income on each additional hour equals the hourly wage minus the marginal tax rate.
• According to this view, the DWL from labor taxes is small. This is relevant to the question “how big should the government be?”, because a high DWL would argue for restraining the size of government.
• The textbook has an “In The News” box containing an excellent WSJ article on the effect of tax rates on work effort.
• The new DWL is four times the initial DWL, even though the tax is just twice as large.
• The new DWL is nine times the initial DWL, even though the tax is only three times as large.
• The “implication” in the green box is not in the textbook, so it is not supported in the study guide or test bank. You may wish to delete it from this slide. If you keep it, note that the “harm” of raising taxes and the “benefit” of lowering them refer to the impact on total surplus.
• When the tax is small (namely, equal to T), the shaded yellow rectangle represents tax revenue. When the tax equals 2T, the pink shaded box represents revenue. The pink shaded box is larger than the yellow box.
• Raising the tax further – to 3T – causes revenue to fall. Revenue is now represented by the bluish-purple shaded box, which is smaller than the pink box.
• The Laffer curves shown here and in the book are symmetric, and their peak occurs in the middle. You might mention to students that this need not and probably is not the case. However, we just don’t know where the peak is – it could be at a tax rate of 20% or a tax rate of 200% - and it surely varies across goods. The textbook has some excellent discussion of the Laffer curve, President Reagan, and supply-side economics. Encourage your students to check it out.
• ### Mankiw chp.8

1. 1. CHAPTE R 8 Application: The Costs of Taxation Microeconomics PRINCIPLES OF N. Gregory Mankiw N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 2010© 2010 South-Western, a part of Cengage Learning, all rights reserved update
2. 2. In this chapter,look for the answers to these questions: How does a tax affect consumer surplus, producer surplus, and total surplus? What is the deadweight loss of a tax? What factors determine the size of this deadweight loss? How does tax revenue depend on the size of the tax? 2
3. 3. Review from Chapter 6 A tax  drives a wedge between the price buyers pay and the price sellers receive.  raises the price buyers pay and lowers the price sellers receive.  reduces the quantity bought & sold. These effects are the same whether the tax is imposed on buyers or sellers, so we do not make this distinction in this chapter.APPLICATION: THE COSTS OF TAXATION 3
4. 4. The Effects of a Tax PEq’m with no tax: Price = PE Quantity = QE Size of tax = \$T PB SEq’m withtax = \$T per unit: PE Buyers pay PB PS D Sellers receive PS Quantity = QT Q QT QEAPPLICATION: THE COSTS OF TAXATION 4
5. 5. The Effects of a Tax P Revenue from tax: \$ T x QT Size of tax = \$T PB S PE PS D Q QT QEAPPLICATION: THE COSTS OF TAXATION 5
6. 6. The Effects of a Tax  Next, we apply welfare economics to measure the gains and losses from a tax.  We determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax.  Tax revenue can fund beneficial services (e.g., education, roads, police) so we include it in total surplus.APPLICATION: THE COSTS OF TAXATION 6
7. 7. The Effects of a Tax P Without a tax, CS = A + B + C PS = D + E + F A Tax revenue = 0 S B C Total surplus PE D E = CS + PS =A+B+C D F +D+E+F Q QT QEAPPLICATION: THE COSTS OF TAXATION 7
8. 8. The Effects of a Tax P With the tax, CS = A PS = F A Tax revenue PB S =B+D B C Total surplus D E =A+B PS D +D+F F The tax reduces total surplus by Q C+E QT QEAPPLICATION: THE COSTS OF TAXATION 8
9. 9. The Effects of a Tax P C + E is called the deadweight loss (DWL) of the tax, A PB S the fall in total B C surplus that results from a D E market distortion, PS D such as a tax. F Q QT QEAPPLICATION: THE COSTS OF TAXATION 9
10. 10. About the Deadweight LossBecause of the tax, Pthe units betweenQT and QE are notsold. S PBThe value of theseunits to buyers isgreater than the cost PS Dof producing them,so the tax preventssome mutually Qbeneficial trades. QT QEAPPLICATION: THE COSTS OF TAXATION 10
11. 11. ACTIVE LEARNING 1 The market forAnalysis of tax P airplane ticketsA. Compute \$ 400 CS, PS, and 350 total surplus 300 without a tax. S 250B. If \$100 tax 200 per ticket, compute 150 D CS, PS, 100 tax revenue, 50 total surplus, 0 Q and DWL. 0 25 50 75 100 125 11
12. 12. ACTIVE LEARNING 1 The market forAnswers to A P airplane ticketsCS \$ 400= ½ x \$200 x 100 350= \$10,000 300 SPS 250= ½ x \$200 x 100 P = 200= \$10,000 150 DTotal surplus 100= \$10,000 + \$10,000 50= \$20,000 0 Q 0 25 50 75 100 125 12
13. 13. ACTIVE LEARNING 1 A \$100 tax onAnswers to B P airplane ticketsCS \$ 400= ½ x \$150 x 75 350= \$5,625 300 SPS = \$5,625 PB = 250Tax revenue 200= \$100 x 75 PS = 150= \$7,500 D 100Total surplus 50= \$18,750 0 QDWL = \$1,250 0 25 50 75 100 125 13
14. 14. What Determines the Size of the DWL?  Which goods or services should govt tax to raise the revenue it needs?  One answer: those with the smallest DWL.  When is the DWL small vs. large? Turns out it depends on the price elasticities of supply and demand.  Recall: The price elasticity of demand (or supply) measures how much QD (or QS) changes when P changes.APPLICATION: THE COSTS OF TAXATION 14
15. 15. DWL and the Elasticity of Supply When supply When supply P is inelastic, is inelastic, S it’s harder for firms it’s harder for firms to leave the market to leave the market when the tax when the tax reduces PSS.. reduces P Size So, the tax only So, the tax only of tax reduces Q a little, reduces Q a little, D and DWL is small. and DWL is small. QAPPLICATION: THE COSTS OF TAXATION 15
16. 16. DWL and the Elasticity of Supply The more elastic is The more elastic is P supply, supply, the easier for firms the easier for firms to leave the market to leave the market S when the tax when the tax reduces PS,, Size reduces PS of tax the greater Q falls the greater Q falls below the surplus- below the surplus- maximizing quantity, maximizing quantity, D the greater the DWL. the greater the DWL. QAPPLICATION: THE COSTS OF TAXATION 16
17. 17. DWL and the Elasticity of Demand P When demand When demand is inelastic, is inelastic, S it’s harder for it’s harder for consumers to consumers to Size leave the market leave the market of tax when the tax when the tax raises PB.. raises PB So, the tax only So, the tax only D reduces Q a little, reduces Q a little, Q and DWL is small. and DWL is small.APPLICATION: THE COSTS OF TAXATION 17
18. 18. DWL and the Elasticity of Demand The more elastic is The more elastic is P demand, demand, S the easier for buyers the easier for buyers to leave the market to leave the market when the tax when the tax Size increases PB,, increases PB of tax D the more Q falls the more Q falls below the surplus- below the surplus- maximizing quantity, maximizing quantity, Q and the greater the and the greater the DWL. DWL.APPLICATION: THE COSTS OF TAXATION 18
19. 19. ACTIVE LEARNING 2Elasticity and the DWL of a taxWould the DWL of a tax be larger if thetax were on: A. Breakfast cereal or sunscreen? B. Hotel rooms in the short run or hotel rooms in the long run? C. Groceries or meals at fancy restaurants? 19
20. 20. ACTIVE LEARNING 2AnswersA. Breakfast cereal or sunscreen From Chapter 5: Breakfast cereal has more close substitutes than sunscreen, so demand for breakfast cereal is more price-elastic than demand for sunscreen. So, a tax on breakfast cereal would cause a larger DWL than a tax on sunscreen. 20
21. 21. ACTIVE LEARNING 2AnswersB. Hotel rooms in the short run or long run From Chapter 5: The price elasticities of demand and supply for hotel rooms are larger in the long run than in the short run. So, a tax on hotel rooms would cause a larger DWL in the long run than in the short run. 21
22. 22. ACTIVE LEARNING 2AnswersC. Groceries or meals at fancy restaurants From Chapter 5: Groceries are more of a necessity and therefore less price-elastic than meals at fancy restaurants. So, a tax on restaurant meals would cause a larger DWL than a tax on groceries. 22
23. 23. ACTIVE LEARNING 3Discussion question The government must raise tax revenue to pay for schools, police, etc. To do this, it can either tax groceries or meals at fancy restaurants. Which should it tax? 23
24. 24. How Big Should the Government Be?  A bigger government provides more services, but requires higher taxes, which cause DWLs.  The larger the DWL from taxation, the greater the argument for smaller government.  The tax on labor income is especially important; it’s the biggest source of govt revenue.  For the typical worker, the marginal tax rate (the tax on the last dollar of earnings) is about 40%.  How big is the DWL from this tax? It depends on elasticity….APPLICATION: THE COSTS OF TAXATION 24
25. 25. How Big Should the Government Be?  If labor supply is inelastic, then this DWL is small.  Some economists believe labor supply is inelastic, arguing that most workers work full-time regardless of the wage.APPLICATION: THE COSTS OF TAXATION 25
26. 26. How Big Should the Government Be? Other economists believe labor taxes are highly distorting because some groups of workers have elastic supply and can respond to incentives:  Many workers can adjust their hours, e.g., by working overtime.  Many families have a 2nd earner with discretion over whether and how much to work.  Many elderly choose when to retire based on the wage they earn.  Some people work in the “underground economy” to evade high taxes.APPLICATION: THE COSTS OF TAXATION 26
27. 27. The Effects of Changing the Size of the Tax Policymakers often change taxes, raising some and lowering others. What happens to DWL and tax revenue when taxes change? We explore this next….APPLICATION: THE COSTS OF TAXATION 27
28. 28. DWL and the Size of the Tax P Initially, the tax is new T per unit. DWL Doubling the tax S causes the DWL 2T T to more than double. D initial DWL Q Q2 Q1APPLICATION: THE COSTS OF TAXATION 28
29. 29. DWL and the Size of the Tax P Initially, the tax is new T per unit. DWL Tripling the tax S causes the DWL 3T T to more than triple. D initial DWL Q Q3 Q1APPLICATION: THE COSTS OF TAXATION 29
30. 30. DWL and the Size of the TaxImplication Implication SummaryWhen tax rates are When tax rates are When a tax increases,low, raising them low, raising them DWL rises even more. DWLdoesn’t cause much doesn’t cause muchharm, and lowering harm, and loweringthem doesn’t bring them doesn’t bringmuch benefit. much benefit.When tax rates are When tax rates arehigh, raising them is high, raising them isvery harmful, and very harmful, andcutting them is very cutting them is very Tax sizebeneficial. beneficial.APPLICATION: THE COSTS OF TAXATION 30
31. 31. Revenue and the Size of the Tax When the P tax is small, increasing it causes tax PB S revenue to rise. PB 2T T PS D PS Q Q2 Q1APPLICATION: THE COSTS OF TAXATION 31
32. 32. Revenue and the Size of the Tax P PB PB S When the 3T 2T tax is larger, increasing it D causes tax PS revenue to fall. PS Q Q3 Q2APPLICATION: THE COSTS OF TAXATION 32
33. 33. Revenue and the Size of the TaxThe Laffer curve Tax The Laffer curveshows therelationship revenuebetweenthe size of the taxand tax revenue. Tax sizeAPPLICATION: THE COSTS OF TAXATION 33
34. 34. CHAPTER SUMMARY A tax on a good reduces the welfare of buyers and sellers. This welfare loss usually exceeds the revenue the tax raises for the govt. The fall in total surplus (consumer surplus, producer surplus, and tax revenue) is called the deadweight loss (DWL) of the tax. A tax has a DWL because it causes consumers to buy less and producers to sell less, thus shrinking the market below the level that maximizes total surplus. 34
35. 35. CHAPTER SUMMARY The price elasticities of demand and supply measure how much buyers and sellers respond to price changes. Therefore, higher elasticities imply higher DWLs. An increase in the size of a tax causes the DWL to rise even more. An increase in the size of a tax causes revenue to rise at first, but eventually revenue falls because the tax reduces the size of the market. 35
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