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8 Application: The Costs of Taxation. CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 2 The Effects of Taxation We saw in Chapter 6 how taxesChapter 6 –reduce.

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Presentation on theme: "8 Application: The Costs of Taxation. CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 2 The Effects of Taxation We saw in Chapter 6 how taxesChapter 6 –reduce."— Presentation transcript:

1 8 Application: The Costs of Taxation

2 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 2 The Effects of Taxation We saw in Chapter 6 how taxesChapter 6 –reduce the equilibrium quantity, –increase the price paid by buyers, and –decrease the price received by sellers. We also saw that –It does not matter whether a tax is placed on the buyers or the sellers; the outcome is the same in either case But how do taxes affect the economic well- being of market participants?

3 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 3 Welfare Economics Welfare economicsWelfare economics is the study of how the allocation of resources affects economic well- being. We saw in Chapter 7 thatChapter 7 –Buyers benefit from buying (consumer surplus), and –Sellers benefit from selling (producer surplus) –The equilibrium outcome in a perfectly competitive market maximizes the total surplus of society.

4 Applying welfare economics to study the effects of taxation In this chapter we will combine what we learned in Chapters 6 and 7 to compare the costs and the benefits of a tax CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 4

5 Figure1 The Effects of a Tax Size of tax Quantity 0 Buyers’ Price Sellers’ price Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax

6 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 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. –See Chapter 6 for detailsChapter 6 This fall in output is the cost of the tax

7 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 7 How a Tax Affects Market Participants Governments earn revenue from taxes This revenue is the benefit of the tax 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 Tax revenue (T × Q) Size of tax (T ) Quantity sold (Q) Quantity 0 Price Demand Supply Quantity without tax Quantity with tax Price buyers pay Price sellers receive

9 Figure 3 How a Tax Affects Welfare A F B D C E Quantity 0 Price Demand Supply = PBPB Q2Q2 = PSPS Price buyers pay Price sellers receive = P1P1 Q1Q1 Price without tax

10 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 10 How a Tax Affects Market Participants A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax.

11 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION11 How a Tax Affects Welfare

12 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 12 How a Tax Affects Market Participants The fall in total welfare includes: –The fall in consumer surplus, –The fall in producer surplus, and –The increase 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 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 13 Deadweight Losses and the Gains from Trade The cost of a tax exceeds the benefit of a tax The decrease in total surplus that is caused by a tax is the deadweight loss of the tax Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.

14 Figure 4 The Deadweight Loss Cost to sellers Value to buyers Size of tax Quantity 0 Price Demand Supply Lost gains from trade Reduction in quantity due to the tax Price without tax Q1Q1 PBPB Q2Q2 PSPS

15 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 15 DETERMINANTS OF THE DEADWEIGHT LOSS What determines whether the deadweight loss from a tax is large or small? –The size of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price. price elasticities –In other words, the size of a tax’s deadweight loss depends on the price elasticities of supply and demand.

16 Figure 5 Tax Distortions and Elasticities (a) Inelastic Supply Price 0Quantity 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 (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 Demand Supply (c) Inelastic Demand Price 0 Quantity Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small.

19 Figure 5 Tax Distortions and Elasticities (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 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 20 DETERMINANTS OF THE DEADWEIGHT LOSS The greater the elasticities of demand and supply: – the larger the decline in equilibrium quantity and, – the greater the deadweight loss of a tax.

21 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 21 The Deadweight Loss Debate Some economists argue that taxes on labor income are highly distorting—that is, taxes on labor income have high deadweight losses—because they believe that labor supply is elastic. –Here are 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 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 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 Tax revenue Demand Supply Quantity 0 Price Q1Q1 (a) Small Tax Deadweight loss PBPB Q2Q2 PSPS

24 Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Tax revenue Quantity 0 Price (b) Medium Tax Supply Demand PBPB Q2Q2 PSPS Deadweight loss When the tax rate doubles, the deadweight loss quadruples Q1Q1

25 Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Tax revenue Demand Supply Quantity 0 Price Q1Q1 (c) Large Tax PBPB Q2Q2 PSPS Deadweight loss

26 Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (d) deadweight loss continually increases Deadweight Loss 0 Tax Size

27 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 27 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 quantity bought and sold shrinks so much that tax revenues start to fall.

28 28 DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY Tax revenue = tax rate × quantity bought and sold –TR = T × Q T↑ causes Q↓ Therefore, the effect of T↑ on TR is ambiguous T↑ causes TR↑ when the tax rate (T) is low T↑ causes TR↓ when the tax rate (T) is high This gives us the Laffer Curve

29 Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (e) Tax revenue first increases, then decreases (the Laffer curve) Tax Revenue 0 Tax Size T1T1 Note that it makes no sense at all to make the tax size bigger than T 1.

30 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 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 view that a tax cut –would induce more people to work, and thereby –have the potential to increase tax revenues. Large tax cuts were adopted during the Reagan administration The results do not settle the debate on the validity of supply-side economics

31 CASE STUDY: The Laffer Curve and Supply-Side Economics Between the early 1970s and mid 1990s, the French tax rate rose to 59 percent from 49 percent, while the U.S. tax rate held at 40 percent The average French person of working age logged 24.4 hours a week in the early 1970s, one hour more than an American. By the mid 1990s, the French workweek had shrunk to 17.5 hours, while the U.S. workweek had grown to 25.9 hours –Data from research by Edward Prescott CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 31

32 CASE STUDY: The Laffer Curve and Supply-side Economics CountryTax RateWorkweek Italy64%16.5 hours France Germany Canada UK USA Japan CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 32 Data from research by Edward Prescott

33 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 33 The Price of a Civilized Society This chapter has focused on the negative effects of taxes on buyers and sellers in a market However, without taxes we would not have a functioning government As Oliver Wendell Holmes, Jr., Supreme Court Justice, once said, “Taxes are the price we pay for a civilized society."

34 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 34 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.

35 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 35 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.

36 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 36 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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