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Lect08
Lect08
Lect08
Lect08
Lect08
Lect08
Lect08
Lect08
Lect08
Lect08
Lect08
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Lect08
Lect08
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Lect08

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  • 1. Application: The Costs of Taxation Chapter 8
  • 2. The Costs of Taxation How do taxes affect the economic well-being of market participants?
  • 3. The Costs 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.
  • 4. The Effects of a Tax... Price Supply Size of tax Price buyers pay Price without tax Price sellers receive Demand 0 Quantity with tax Quantity without tax Quantity
  • 5. The Effects of a Tax 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.
  • 6. Tax Revenue T = the size of the tax Q = the quantity of the good sold T×Q = the government’s tax revenue
  • 7. Tax Revenue... Price Supply Price buyers pay Size of tax (T) Tax Revenue (T x Q) Price sellers receive Quantity sold (Q) 0 Quantity with tax Demand Quantity without tax Quantity
  • 8. How a Tax Affects Welfare... Tax reduces consumer surplus by (B+C) and producer surplus by (D+E) Price Price buyers pay = P B Price without = tax Price = sellers receive Tax revenue = (B+D) A B P1 PS 0 C Deadweight Loss = (C+E) E D Supply F Demand Q2 Q1 Quantity
  • 9. Changes in Welfare from a Tax Without Tax With Tax Change Consumer Surplus A + B + C A - (B + C) Producer Surplus D + E + F F - (D + E) none B + D + (B + D) Tax Revenue Total Surplus A + B + C + D + E + F A + B + D + F - (C + E ) The area C+E shows the fall in total surplus and is the deadweight loss of the tax.
  • 10. How a Tax Affects Welfare The change in total welfare includes: The change in consumer surplus, The change in producer surplus, 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.
  • 11. 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.
  • 12. The Deadweight Loss... Price Lost gains from trade PB Price = P 1 without tax Supply Size of tax P S Cost to sellers Value to buyers 0 Q2 Q1 Demand Quantity Reduction in quantity due to the tax
  • 13. Determinants of 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.
  • 14. Tax Distortions and Elasticities... (a) Inelastic Supply Supply Price When supply is relatively inelastic, the deadweight loss of a tax is small. Size of tax Demand 0 Quantity
  • 15. Tax Distortions and Elasticities... (b) Elastic Supply Price When supply is relatively elastic, the deadweight loss of a tax is large. Supply Size of tax Demand 0 Quantity
  • 16. Tax Distortions and Elasticities... (c) Inelastic Demand Price Supply Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small. Demand 0 Quantity
  • 17. Tax Distortions and Elasticities... (d) Elastic Demand Price Supply Size of tax When demand is relatively elastic, the deadweight loss of a tax is large. 0 Demand Quantity
  • 18. Determinants of 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.
  • 19. The Deadweight Loss Debate Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic.
  • 20. The Deadweight Loss Debate 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)
  • 21. 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.
  • 22. Deadweight Loss and Tax Revenue... (a) Small Tax Price Supply Deadweight loss PB PS Tax revenue Demand 0 Q2 Q1 Quantity
  • 23. Deadweight Loss and Tax Revenue... (b) Medium Tax Price Supply Deadweight loss PB Tax revenue PS 0 Demand Q2 Q1 Quantity
  • 24. Deadweight Loss and Tax Revenue... (c) Large Tax Price Supply PB Tax reve nue Deadweight loss Demand PS 0 Q2 Q1 Quantity
  • 25. Deadweight Loss 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.
  • 26. Deadweight Loss and Tax Revenue Vary with the Size of the Tax... (a) Deadweight Loss Deadweight Loss 0 Tax Size
  • 27. Deadweight Loss and Tax Revenue Vary with the Size of the Tax... Tax Revenue 0 (b) Revenue (the Laffer curve) Tax Size
  • 28. Deadweight Loss and Tax Revenue Vary with the Size of the Tax 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.
  • 29. 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.
  • 30. 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.
  • 31. Summary 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.

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