In this chapter you will examine how taxes reduce consumer and producer surplus, learn the meaning and causes of the deadweight loss of a tax, consider why some taxes have larger deadweight losses than others, examine how tax revenue and deadweight loss vary with the size of a tax.
Application: The Costs of Taxation Copyright©2004 South-Western Application: The Costs of Taxation • Welfare economics is the study of how the Welfare economics allocation of resources affects economic well being • Buyers and sellers receive benefits from taking part inthemarket. Theequilibriuminamarketmaximizesthetotal welfareofbuyersandsellers. Copyright â 2004 South-Western/Thomson Learning THE DEADWEIGHT LOSS OF TAXATION Howdotaxesaffecttheeconomicwellưbeingof marketparticipants? Copyright â 2004 South-Western/Thomson Learning 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 Copyright © 2004 South-Western/Thomson Learning Figure The Effects of a Tax Price Supply Price buyers pay Size of tax Price without tax Price sellers receive Demand Quantity with tax Quantity without tax Quantity Copyright © 2004 South-Western How a Tax Affects Market Participants • Ataxplacesawedgebetweenthepricebuyers payandthepricesellersreceive. Becauseofthistaxwedge,thequantitysold fallsbelowthelevelthatwouldbesoldwithout atax Thesizeofthemarketforthatgoodshrinks Copyright â 2004 South-Western/Thomson Learning How a Tax Affects Market Participants • TaxRevenue T=thesizeofthetax Q=thequantityofthegoodsold T Q=thegovernmentstaxrevenue Copyright â 2004 South-Western/Thomson Learning Figure Tax Revenue Price Supply Price buyers pay Size of tax (T) Tax revenue (T × Q) Price sellers receive Demand Quantity sold (Q) Quantity with tax Quantity without tax Quantity Copyright © 2004 South-Western Figure How a Tax Effects Welfare Price Price buyers = PB pay Supply A B C Price without tax = P1 Price sellers = PS receive E D F Demand Q2 Q1 Quantity Copyright © 2004 South-Western 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 Copyright © 2004 South-Western/Thomson Learning Figure Tax Distortions and Elasticities (d) Elastic Demand Price Supply Size of tax Demand When demand is relatively elastic, the deadweight loss of a tax is large Quantity Copyright © 2004 South-Western 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 Copyright © 2004 South-Western/Thomson Learning 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) Copyright © 2004 South-Western/Thomson Learning 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 Copyright © 2004 South-Western/Thomson Learning Figure Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes (a) Small Tax Price Deadweight loss Supply PB Tax revenue PS Demand Q2 Q1 Quantity Copyright © 2004 South-Western Figure Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes (b) Medium Tax Price Deadweight loss PB Supply Tax revenue PS Demand Q2 Q1 Quantity Copyright © 2004 South-Western Figure Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes (c) Large Tax Price PB Tax revenue Deadweight loss Supply Demand PS Q2 Q1 Quantity Copyright © 2004 South-Western 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 Copyright © 2004 South-Western/Thomson Learning Figure How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (a) Deadweight Loss Deadweight Loss Tax Size Copyright © 2004 South-Western Figure How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (b) Revenue (the Laffer curve) Tax Revenue Tax Size Copyright © 2004 South-Western DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY • As the size of a tax increases, its deadweight lossquicklygetslarger Bycontrast,taxrevenuefirstriseswiththesize ofatax,butthen,asthetaxgetslarger,the marketshrinkssomuchthattaxrevenuestarts tofall Copyright â 2004 South-Western/Thomson Learning CASE STUDY: The Laffer Curve and Supplyside Economics • TheLaffercurvedepictstherelationship betweentaxratesandtaxrevenue Supplyưsideeconomicsreferstotheviewsof ReaganandLafferwhoproposedthatataxcut wouldinducemorepeopletoworkandthereby havethepotentialtoincreasetaxrevenues Copyright â 2004 South-Western/Thomson Learning 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,producersurplus,andtaxrevenueis calledthedeadweightlossofthetax Copyright â 2004 South-Western/Thomson Learning Summary Taxeshaveadeadweightlossbecausethey causebuyerstoconsumelessandsellersto produceless Thischangeinbehaviorshrinksthesizeofthe marketbelowthelevelthatmaximizestotal surplus Copyright â 2004 South-Western/Thomson Learning 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 Copyright © 2004 South-Western/Thomson Learning .. .Application: The Costs of Taxation • Welfare economics is the study of how the Welfare economics allocation of resources affects economic well being... 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 Copyright © 2004 South-Western/Thomson... 2004 South-Western 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