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Mankiw chp.8

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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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