Principles of Microeconomics Module 2.4 Taxation

Taxes in the Supply and Demand Model Taxes cause: Price paid by buyer > Price received by seller Insert “wedge” in the Supply and Demand model Tax wedge creates deadweight loss: Loss of total surplus or economic well-being as a result of the policy

Sales Taxes Taxes insert a wedge between the price paid by buyers (Pb) and price received by sellers (Ps) Regardless of who pays the tax (sellers or buyers) both share the tax burden Tax = Pb – Ps Tax revenue = Tax*Qt Tax burden (buyer) = Pb – Pe Tax burden (seller) = Pe - Ps P PB TAX PS Qt Qe Q

Sales Taxes Taxes insert a wedge between the price paid by buyers (Pb) and price received by sellers (Ps) Regardless of who pays the tax (sellers or buyers) both share the tax burden Tax = Pb – Ps Tax revenue = Tax*Qt Tax burden (buyer) = Pb – Pe Tax burden (seller) = Pe - Ps P PB TAX PS Qt Qe Q

Sales Taxes Taxes insert a wedge between the price paid by buyers (Pb) and price received by sellers (Ps) Regardless of who pays the tax (sellers or buyers) both share the tax burden Tax = Pb – Ps Tax revenue = Tax*Qt Tax burden (buyer) = Pb – Pe Tax burden (seller) = Pe - Ps P PB REVENUE TAX PS Qt Qe Q

Understanding Taxes Consider the market for socks, where the equilibrium price of socks is $5 per pair and the equilibrium quantity is 300. The government imposes a $1 tax on the market to be paid by the seller, causing a fall in the quantity sold to 200. What happens when the tax is imposed? Draw out the supply and demand model showing the market before the tax and after the tax

Understanding Taxes S P Pe = $5 D Q Qe = 300

Understanding Taxes S P Pb = $5.50 Tax: Pb – Ps Pe = $5 $1 Pb = $4.50 Q Qt = 200 Qe = 300

Understanding Taxes Tax Revenue = Tax*Qt $1 * 200 = $200 S P Pb = $5.50 Tax: Pb – Ps $1 Tax Revenue = Tax*Qt $1 * 200 = $200 Pe = $5 Pb = $4.50 D Q Qt = 200 Qe = 300

Application Reflection Why does this matter? It doesn’t matter who pays the tax, both the buyer and seller are burdened when a tax is imposed on the market Buyers must pay more, sellers must receive a lower price for the same good Taxes create a distortion in the market because of the mismatch between price paid by the buyer and price received by the seller Here, the social benefits associated with government spending from the tax revenue (schools, defense, infrastructure ect.) outweigh the economic costs of the tax burden What’s the most important takeaway? Taxes create distortions through their impact of prices paid by buyers and received by sellers Taxes cause: Prices to rise for buyers (pay more) and prices to fall for sellers (receive less) – total Q falls MUDDIEST POINT?

How do taxes affect Market Participants? Analyze the following before tax vs. after tax is imposed: Consumer Surplus Producer Surplus Total Surplus Government Revenue How does the tax change economic welfare?

Consumer Surplus BEFORE TAXES AFTER TAXES S S P P Pb Pe Pe Ps D D Q Qe Qt Q Qe

Producer Surplus BEFORE TAXES AFTER TAXES S S P P Pb Pe Pe Ps D D Q Qe Qt Q Qe

Government Tax Revenue BEFORE TAXES AFTER TAXES S S P P Pb Gov’t Tax Revenue Pe Pe Producer Surplus Ps D D Q Qe Qt Q Qe

Deadweight Loss BEFORE TAXES AFTER TAXES S S P P Pb Pe Pe Ps D D Q Qe DWL Producer Surplus Ps D D Q Qe Qt Q Qe

Elasticity and the Tax Burden

Application 1 Consider the market for paperclips where the equilibrium price is $0.50 and equilibrium quantity is 1000 units. Assume the government imposes a $0.20 tax and we have equal supply and demand price elasticity. What is the price paid by buyers? What is the price received by sellers? What is the tax revenue, assuming Qt = 800? - Calculate the size of deadweight loss

Application 1 continued Now what if the tax is doubled and the new Qt is 400? What is the price paid by buyers? What is the price received by sellers? What is the tax revenue? Calculate the size of deadweight loss What observation can you make regarding tax revenue in both cases?

Application Reflection Why does this matter? When taxes are imposed, the distortion they cause leads to a decrease in consumer surplus and producer surplus The larger the tax, the greater the impact it has on lowering CS and PS But a larger tax also corresponds with a larger tax revenue – government can provide more public goods and services so there is some benefit to it as well. Depending on the impact on quantity sold of the good – two different tax rates can yield the same tax revenue! What’s the most important takeaway? Higher tax and lower tax can yield the same government tax revenue - depending on their impact on quantity sold Always the higher tax = higher loss in CS and PS MUDDIEST POINT?

Laffer Curve and Tax Revenue High tax rate is not necessarily better than low tax rate for tax revenue What implication does this have on public policy? Where would be the “optimal tax rate”

Key Takeaways We can think of taxation in the context of supply and demand model in terms of How it affects prices and quantities How it affects economic well-being via welfare economics Since taxes cause distortions in the market (tax wedge) they yield inefficient market outcomes Why do we have them? Derive some benefits from government revenue.