Taxes & Subsidies Economic Welfare Supplement

How Do We Analyze the Effects of Taxes and Subsidies The efficient ideal market “perfectly competitive” market Consumers and suppliers are price-takers, i.e. have no market power

Total Social Welfare Ideally the impact of a program should be evaluated as: {Pareto efficient} 1) can at least one person’s welfare be improved 2) without making anyone worse off http://en.wikipedia.org/wiki/Pareto_efficiency More realistically: Could the winners compensate the losers? {Pigouvian} Is the deadweight loss of the taxed good less than the surplus gain from the subsidized good? http://en.wikipedia.org/wiki/Pigovian_tax

Deadweight Loss Price Consumers Pay Pre-tax price Price Sellers Receive Reduction in Qty sold

Deadweight Loss Retained CS Tax Rev From CS Tax Rev From CS Retained PS

How Do We Evaluate the Impact of the Tax? Two Parts: Tax Incidence Who pays for it more? Consumers or Producers? Will depend on relative demand/supply elasticities Economic welfare analysis Does the tax (revenue) improve social welfare? Will depend on relative elasticities of: a) good taxed B) good or program financed by the tax

What Are the Benefits? Depends on what we do with the taxes Suppose we use it to subsidize another good Subsidy appears as a reduction in per-unit costs to the firm getting the subsidy

Evaluating The Impact Costs: Benefits Will Benefits > Tax Deadweight loss: sum of reduction in consumer and producer surplus for the taxed good Reflects reduction in Qd and higher price paid Benefits Gain in CS and PS from subsidized cost Will Benefits > Tax Depends on the relative demand elasticities for the 2 goods

Evaluating the Impact “A Positive Analysis” (Distributional Consequences) Who gains/loses from the tax and subsidy? Both producers and consumers of the taxed good lose (in terms of lost surpluses) Relative demand/elasticities determine who loses most More inelastic demand -> greater is CS loss Producers and Consumers of subsidized good win (lower price and more Q) Relative demand supply elasticities determine who benefits most

Total Social Welfare Ideally the impact of a program should be evaluated as: {Pareto efficient} 1) can any one (or more) person’s welfare be improved 2) without any one else’s welfare being reduced http://en.wikipedia.org/wiki/Pareto_efficiency More realistically: Could the winners compensate the losers? {Pigouvian} Is the deadweight loss of the taxed good less than the surplus gain from the subsidized good? http://en.wikipedia.org/wiki/Pigovian_tax