1. Chapter 8 The Costs of Taxation

2. Objectives 1. Understand how taxes reduce consumer and producer surplus 2. Learn the causes and significance of the deadweight loss of a tax 3. Know why some taxes have larger deadweight losses than others 4. Understand the relationship among deadweight loss, tax revenue, and the size of a tax

3. The Costs of Taxation How does the application of a tax affect the market system? Review Chapter 6 & 7!

4. 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.

5. Market Efficiency: Three observations u Free markets allocate the supply of goods to the buyers who value them most highly. u Free markets allocate the demand for goods to the sellers who can produce them at least cost. u Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.

6. Consumer Surplus: Verbal Definition The amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. D

7. Producer Surplus: Verbal Definition The amount a seller is paid minus the cost of production. Producer surplus measures the benefit to sellers of participating in a market. S

8. Market Efficiency u Under the assumptions of perfect competition, no externalities, and no taxes the economic well-being of a society is measured as the sum of consumer surplus and producer surplus. u Market Efficiency is attained when total surplus is maximized, a point where resource allocation is efficient.

9. Market Efficiency S D PEPE Consumer Surplus Producer Surplus

10. Taxes! Taxes! Taxes! u Who pays the tax on a good? The buyer or the seller? u How is the burden of a tax divided between buyer and seller? When the government levies a tax on a good, the equilibrium quantity of the good falls. The size of the market for that good shrinks.

11. The Costs of Taxation u A tax places a wedge between the price buyers pay and the price sellers receive. Tax!

12. The Costs of Taxation u A tax places a wedge between the price buyers pay and the price sellers receive. u A tax results in a Deadweight Loss to society and the economy Tax! Loss!

13. How a Tax Affects Welfare... Quantity0 Price Demand Supply Q1Q1 A B C F D E Q2Q2 Tax reduces consumer surplus by (B+C) and producer surplus by (D+E) Tax revenue = (B+D) Deadweight Loss = (C+E) Price buyers pay = PBPB P1P1 Price without tax = PSPS Price sellers receive =

14. Changes in Welfare from a Tax Without TaxWith TaxChange Consumer SurplusA + B + CA- (B + C) Producer SurplusD + E + FF- (D + E) Tax RevenuenoneB + D+ (B + D) Total SurplusA + B + C + D + E + FA + B + D + F- (C + E ) The area C+E shows the fall in total surplus and is the deadweight loss of the tax.

15. How a Tax Affects Welfare The change in total welfare includes: u The change in consumer surplus, u The change in producer surplus, u The change in tax revenue. u The losses to buyers and sellers exceed the revenue raised by the government. u This fall in total surplus is called the deadweight loss.

16. Tax Revenue T = the size of the tax Q = the quantity of the good sold T  Q = the government’s tax revenue

17. Tax Revenue... Price 0 Quantity Quantity without tax Supply Demand Price sellers receive Quantity with tax Size of tax (T) Quantity sold (Q) Tax Revenue (T x Q) Price buyers pay

18. Deadweight Loss Deadweight Loss is the reduction in total surplus that results from a tax

19. Deadweight Loss of Taxation u When a tax is levied on buyers, the demand curve shifts downward by the size of the tax. u When a tax is levied on sellers, the supply curve shifts upward by that amount. u The losses to buyers and sellers exceed the tax revenue, leading to a Deadweight Loss.

20. Deadweight Loss of Taxation: Example u The current market situation of $0.50 per unit of a product results in 1,000 units being offered for sale and purchased. u A twenty cent tax ($0.20) is imposed on the suppliers. Sellers “collect” the tax and send the tax revenue to the government.

21. Deadweight Loss of Taxation: Graphical $.50 1000 Demand Supply

22. Deadweight Loss of Taxation: Graphical $.50 1000 Demand Supply $.60 $.40 800 $.20 tax imposed

23. Deadweight Loss of Taxation: Example u The twenty cent tax results in new prices to consumers and producers: –Consumers pay $0.60 –Sellers receive $0.40 u The Tax Revenue from the imposed tax is = $160 i.e. [($0.60-$0.40) x 800]

24. Deadweight Loss of Taxation: Graphical $.50 1000 Demand Supply $.60 $.40 800 Tax Revenue

25. T = the size of the tax Q = the quantity of the good sold T  Q = the government’s tax revenue

26. Deadweight Loss of Taxation u The tax places a wedge between the price buyers pay and the price seller receive. The higher price to buyers and the lower price to sellers results in a lower quantity demanded and quantity supplied. u The loss in quantity demanded and the quantity supplied is 200 units (1000 - 800).

27. Deadweight Loss of Taxation: Graphical $.50 1000 Demand Supply $.60 $.40 800 Loss in Quantity

28. Deadweight Loss of Taxation: Graphical $.50 1000 Demand Supply $.60 $.40 800 Deadweight Loss!

29. Deadweight Loss of Taxation, example u The deadweight loss of 200 units do no one any good –The value of the loss to society due to the twenty cent tax is = $20 ($500 - $480) u Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.

30. The Deadweight Loss { Size of Tax Supply Demand Quantity Price 0 Cost to sellers Cost to buyers } Lost gains from trade Price w/o tax Reduction in quantity due to the tax Q2Q2 Q1Q1 PSPS PBPB

31. Determinants of Deadweight Loss u The magnitude of the Deadweight Loss depends upon how large a decline in market exchange occurs as a result of the tax. u The size in the decline in market exchange depends upon how sensitive consumers and producers are to changes in prices: Elasticity Concept.

32. How a Tax Affects Welfare Q Demand Supply Price buyers pay 0 Price without tax Price seller receive 2 Q 1 P s P 1 P B Price A B D F

33. How a Tax Affects Welfare Q Demand Supply Price buyers pay 0 Price without tax Price seller receives 2 Q 1 P s P 1 P B Price A B D F C E

34. Changes in Welfare From a Tax Consumer surplus Producer surplus Tax revenue Total surplus Consumer surplus Producer surplus Tax revenue Total surplus Without TaxWithTaxChange A+B+CD+E+FNoneA+B+C+D+E+FA+B+CD+E+FNoneA+B+C+D+E+FAFB+DA+B+D+FAFB+DA+B+D+F - (B+C) - (D+E) + (B+D) - (C+E) - (B+C) - (D+E) + (B+D) - (C+E)

35. Changes in Welfare From a Tax0$.20$.40$.60$.80$1.000$.20$.40$.60$.80$1.00 Tax (cents/roll) Consumer Pay Sellers Receive Quantity Exchanged Tax Revenue Deadweight Loss $.50$.60$.70$.80$.900$.50$.60$.70$.80$.900$.50$.40$.30$.20$.100$.50$.40$.30$.20$.10010008006004002000100080060040020000$160$240$240$16000$160$240$240$16000$20$80$180$320$5000$20$80$180$320$500

36. Determinants of Deadweight Loss The more elastic demand and supply are, the greater will be the decline in equilibrium quantity and the greater the Deadweight Loss.

37. Tax Distortions and Elasticities a) Inelastic Supply When supply is relatively inelastic, the deadweight loss of a tax is small. { Size of Tax Quantity Price Supply Demand 0

38. Tax Distortions and Elasticities b) Elastic Supply When supply is relatively inelastic, the deadweight loss of a tax is large. { Size of Tax Supply Demand Quantity Price 0

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

40. Tax Distortions and Elasticities d) Elastic Demand When demand is relatively inelastic, the deadweight loss of a tax is large. { Size of Tax Supply Demand Quantity Price 0

41. Determinants of Deadweight Loss u A tax has a deadweight loss because it induces buyers and sellers to change their behavior. –Higher prices cause buyers to buy less. –Lower prices received causes sellers to offer less. u The size of the market shrinks below the optimum. (Figure 8-6)

42. The Deadweight Loss Debate Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic.

43. The Deadweight Loss Debate Some examples of workers who may respond more to incentives: u Workers who can adjust the number of hours they work u Families with second earners u Elderly who can choose when to retire u Workers in the underground economy (i.e. those engaging in illegal activity)

44. 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.

45. Tax Revenue Deadweight Loss and Tax Revenue a) Small Tax 0 PSPS PBPB Q2Q2 Q1Q1 Deadweight Loss Supply Demand Price Quantity

46. Tax Revenue Deadweight Loss and Tax Revenue a) Medium Tax 0 PSPS PBPB Q2Q2 Q1Q1 Deadweight Loss Supply Demand Price Quantity

47. Tax Revenue Deadweight Loss and Tax Revenue a) Large Tax 0 PSPS PBPB Q2Q2 Q1Q1 Deadweight Loss Supply Demand Price Quantity

48. Less Elastic Demand and Supply S0S0 D0D0 QEQE PEPE S2S2 P2P2 Q2Q2 Amount of Tax

49. Less Elastic Demand and Supply S0S0 D0D0 QEQE PEPE S2S2 P2P2 Q2Q2 Amount of Tax Deadweight Loss!

50. Deadweight Loss and Tax Revenue u The deadweight loss of a tax rises even more rapidly than the size of the tax. –It is related to the area of a triangle. If we double the tax, the size of the triangle increases four times. u With each increase in the tax rate, tax revenues will rise slowly, reach a maximum, and decline.

51. The Costs of Taxation: Conclusion u When a tax is imposed on a good, the tax reduces consumer and producer surplus by an amount that is greater than the tax revenue generated. u The difference between the decrease in total consumer and producer surplus and the tax revenue generated is referred to as the Deadweight Loss of a tax.

52. u With the increase in the tax rate, the percentage decrease in market equilibrium quantity becomes greater. Tax revenues begin to decrease. u As the tax gets larger, the deadweight loss increases more proportionate than the tax increase. The Costs of Taxation: Conclusion

53. Changes in Welfare From a Tax0$.20$.40$.60$.80$1.000$.20$.40$.60$.80$1.00 Tax (cents/roll) Consumer Pay Sellers Receive Quantity Exchanged Tax Revenue Deadweight Loss $.50$.60$.70$.80$.900$.50$.60$.70$.80$.900$.50$.40$.30$.20$.100$.50$.40$.30$.20$.10010008006004002000100080060040020000$160$240$240$16000$160$240$240$16000$20$80$180$320$5000$20$80$180$320$500

54. Deadweight Loss and Tax Revenue Vary with the Size of the Tax... (a) Deadweight Loss Deadweight Loss 0 Tax Size

55. Deadweight Loss and Tax Revenue Vary with the Size of the Tax... (b) Revenue (the Laffer curve) Tax Revenue 0Tax Size

56. The Laffer Curve and Supply-Side Economics u The Laffer curve depicts the relationship between tax rates and tax revenue. u 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.

57. 2. When taxes are imposed, however, markets loose some of their efficiency. Taxes alter incentives and distort market outcomes 1. Since we all expect government to provide certain services such as roads, police and national defense, it is necessary to raise revenue. Conclusion