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  • 1. 8 Application: The Costs of Taxation
  • 2. Application: The Costs of Taxation
    • Welfare economics is the study of how the allocation of resources affects economic well-being.
      • Buyers and sellers receive benefits from taking part in the market.
      • The equilibrium in a market maximizes the total welfare of buyers and sellers.
  • 3. THE DEADWEIGHT LOSS OF TAXATION
    • How do taxes affect the economic well-being of market participants?
  • 4. THE DEADWEIGHT LOSS OF TAXATION
    • 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.
  • 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
    • A tax places a wedge between the price buyers pay and the price sellers receive.
    • Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax.
    • The size of the market for that good shrinks.
  • 7. How a Tax Affects Market Participants
    • Tax Revenue
      • T = the size of the tax
      • Q = the quantity of the good sold
      • T  Q = the government’s tax revenue
  • 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
    • Changes in Welfare
      • A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax.
  • 11. How a Tax Affects Welfare
  • 12. How a Tax Affects Market Participants
    • The change in total welfare includes:
      • The change in consumer surplus,
      • The change in producer surplus, and
      • The change in tax revenue.
      • The losses to buyers and sellers exceed the revenue raised by the government.
      • This fall in total surplus is called the deadweight loss.
  • 13. Deadweight Losses and the Gains from Trade
    • Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.
  • 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
    • What determines whether the deadweight loss from a tax is large or small?
      • The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price.
      • That, in turn, depends on the price elasticities of supply and demand.
  • 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
    • The greater the elasticities of demand and supply:
      • the larger will be the decline in equilibrium quantity and,
      • the greater the deadweight loss of a tax.
  • 21. DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY
    • The Deadweight Loss Debate
      • Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic.
      • Some examples of workers who may respond more to incentives:
        • Workers who can adjust the number of hours they work
        • Families with second earners
        • Elderly who can choose when to retire
        • Workers in the underground economy (i.e., those engaging in illegal activity)
  • 22. DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY
    • With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax.
  • 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
    • 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.
  • 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
    • 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.
  • 30. CASE STUDY: The Laffer Curve and Supply-side Economics
    • The Laffer curve depicts the relationship between tax rates and tax revenue.
    • 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.
  • 31. Summary
    • 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.
    • The fall in total surplus—the sum of consumer surplus, producer surplus, and tax revenue — is called the deadweight loss of the tax.
  • 32. Summary
    • Taxes have a deadweight loss because they cause buyers to consume less and sellers to produce less.
    • This change in behavior shrinks the size of the market below the level that maximizes total surplus.
  • 33. Summary
    • As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger.
    • Tax revenue first rises with the size of a tax.
    • Eventually, however, a larger tax reduces tax revenue because it reduces the size of the market.