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  • 1. 8 Application: The Costs of Taxation
  • 2. Application: The Costs of Taxation <ul><li>Welfare economics is the study of how the allocation of resources affects economic well-being. </li></ul><ul><ul><li>Buyers and sellers receive benefits from taking part in the market. </li></ul></ul><ul><ul><li>The equilibrium in a market maximizes the total welfare of buyers and sellers. </li></ul></ul>
  • 3. THE DEADWEIGHT LOSS OF TAXATION <ul><li>How do taxes affect the economic well-being of market participants? </li></ul>
  • 4. THE DEADWEIGHT LOSS OF TAXATION <ul><li>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. </li></ul>
  • 5. Figure 1 The Effects of a Tax Copyright © 2004 South-Western Quantity 0 Price Size of tax Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax
  • 6. How a Tax Affects Market Participants <ul><li>A tax places a wedge between the price buyers pay and the price sellers receive. </li></ul><ul><li>Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax. </li></ul><ul><li>The size of the market for that good shrinks. </li></ul>
  • 7. How a Tax Affects Market Participants <ul><li>Tax Revenue </li></ul><ul><ul><li>T = the size of the tax </li></ul></ul><ul><ul><li>Q = the quantity of the good sold </li></ul></ul><ul><ul><li>T  Q = the government’s tax revenue </li></ul></ul>
  • 8. Figure 2 Tax Revenue Copyright © 2004 South-Western Quantity 0 Price Tax revenue ( T × Q) Size of tax ( T ) Quantity sold ( Q ) Demand Supply Quantity without tax Quantity with tax Price buyers pay Price sellers receive
  • 9. Figure 3 How a Tax Effects Welfare Copyright © 2004 South-Western Quantity 0 Price A F B D C E Demand Supply = P B Q 2 = P S Price buyers pay Price sellers receive = P 1 Q 1 Price without tax
  • 10. How a Tax Affects Market Participants <ul><li>Changes in Welfare </li></ul><ul><ul><li>A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax. </li></ul></ul>
  • 11. How a Tax Affects Welfare
  • 12. How a Tax Affects Market Participants <ul><li>The change in total welfare includes: </li></ul><ul><ul><li>The change in consumer surplus, </li></ul></ul><ul><ul><li>The change in producer surplus, and </li></ul></ul><ul><ul><li>The change in tax revenue. </li></ul></ul><ul><ul><li>The losses to buyers and sellers exceed the revenue raised by the government. </li></ul></ul><ul><ul><li>This fall in total surplus is called the deadweight loss. </li></ul></ul>
  • 13. Deadweight Losses and the Gains from Trade <ul><li>Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade. </li></ul>
  • 14. Figure 4 The Deadweight Loss Copyright © 2004 South-Western Quantity 0 Price Cost to sellers Value to buyers Size of tax Demand Supply Lost gains from trade Reduction in quantity due to the tax Price without tax Q 1 P B Q 2 P S
  • 15. DETERMINANTS OF THE DEADWEIGHT LOSS <ul><li>What determines whether the deadweight loss from a tax is large or small? </li></ul><ul><ul><li>The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price. </li></ul></ul><ul><ul><li>That, in turn, depends on the price elasticities of supply and demand. </li></ul></ul>
  • 16. Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (a) Inelastic Supply Price 0 Quantity Demand Supply Size of tax When supply is relatively inelastic, the deadweight loss of a tax is small.
  • 17. Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (b) Elastic Supply Price 0 Quantity Demand Supply Size of tax When supply is relatively elastic, the deadweight loss of a tax is large.
  • 18. Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (c) Inelastic Demand Price 0 Quantity Demand Supply Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small.
  • 19. Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (d) Elastic Demand Price 0 Quantity Size of tax Demand Supply When demand is relatively elastic, the deadweight loss of a tax is large.
  • 20. DETERMINANTS OF THE DEADWEIGHT LOSS <ul><li>The greater the elasticities of demand and supply: </li></ul><ul><ul><li>the larger will be the decline in equilibrium quantity and, </li></ul></ul><ul><ul><li>the greater the deadweight loss of a tax. </li></ul></ul>
  • 21. DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY <ul><li>The Deadweight Loss Debate </li></ul><ul><ul><li>Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic. </li></ul></ul><ul><ul><li>Some examples of workers who may respond more to incentives: </li></ul></ul><ul><ul><ul><li>Workers who can adjust the number of hours they work </li></ul></ul></ul><ul><ul><ul><li>Families with second earners </li></ul></ul></ul><ul><ul><ul><li>Elderly who can choose when to retire </li></ul></ul></ul><ul><ul><ul><li>Workers in the underground economy (i.e., those engaging in illegal activity) </li></ul></ul></ul>
  • 22. DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY <ul><li>With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax. </li></ul>
  • 23. Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Copyright © 2004 South-Western Quantity 0 Price (a) Small Tax Tax revenue Demand Supply Q 1 Deadweight loss P B Q 2 P S
  • 24. Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Copyright © 2004 South-Western Quantity 0 Price (b) Medium Tax Tax revenue P B Q 2 P S Supply Demand Q 1 Deadweight loss
  • 25. Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Copyright © 2004 South-Western Quantity 0 Price (c) Large Tax Tax revenue Demand Supply Q 1 P B Q 2 P S Deadweight loss
  • 26. DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY <ul><li>For the small tax, tax revenue is small. </li></ul><ul><li>As the size of the tax rises, tax revenue grows. </li></ul><ul><li>But as the size of the tax continues to rise, tax revenue falls because the higher tax reduces the size of the market. </li></ul>
  • 27. Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax Copyright © 2004 South-Western (a) Deadweight Loss Deadweight Loss 0 Tax Size
  • 28. Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax Copyright © 2004 South-Western (b) Revenue (the Laffer curve) Tax Revenue 0 Tax Size
  • 29. DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY <ul><li>As the size of a tax increases, its deadweight loss quickly gets larger. </li></ul><ul><li>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. </li></ul>
  • 30. CASE STUDY: The Laffer Curve and Supply-side Economics <ul><li>The Laffer curve depicts the relationship between tax rates and tax revenue. </li></ul><ul><li>Supply-side economics refers to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues. </li></ul>
  • 31. Summary <ul><li>A tax on a good reduces the welfare of buyers and sellers of the good, and the reduction in consumer and producer surplus usually exceeds the revenues raised by the government. </li></ul><ul><li>The fall in total surplus—the sum of consumer surplus, producer surplus, and tax revenue — is called the deadweight loss of the tax. </li></ul>
  • 32. Summary <ul><li>Taxes have a deadweight loss because they cause buyers to consume less and sellers to produce less. </li></ul><ul><li>This change in behavior shrinks the size of the market below the level that maximizes total surplus. </li></ul>
  • 33. Summary <ul><li>As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. </li></ul><ul><li>Tax revenue first rises with the size of a tax. </li></ul><ul><li>Eventually, however, a larger tax reduces tax revenue because it reduces the size of the market. </li></ul>

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