© 2007 Thomson South-Western, all rights reserved N. G R E G O R Y M A N K I W PowerPoint ® Slides by Ron Cronovich 8 P R I N C I P L E S O F F O U R T H E D I T I O N Application: The Costs of Taxation

1 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Taxes and Dead Weight Loss  Taxes impose a cost on society that exceeds the value of the revenues collected.  This loss is traceable to the distortion created in the market – discouraging transactions between willing buyers and sellers that would otherwise occur. We call this “dead weight loss.”  The loss arises because the economy no longer meets the efficiency conditions.  This distortion will be illustrated below using the concept of Total Surplus, from Ch.7.

2 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION “Dead Weight Loss” Defined  Dead Weight Loss: the fall in total surplus that results from a market distortion (such as a tax on transactions between buyers and sellers). P. 163  Other examples: Price regulations or subsidies that shift the market equilibrium away from the competitive equilibrium. A price ceiling on gasoline is a good example.  The efficiency loss? Willingness to Pay NE Seller’s Cost. (for the marginal buyer and seller)

3 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Deadweight Loss when Price Controls Distort the Competitive Equilibrium P Q D S PSPS PBPB QEQE QTQT If a price floor is established at P(B), the units between Q T and Q E are not sold. The value of these units to buyers is greater than the cost of production, preventing some mutually beneficial trades, and creating Dead Weight Loss!

4 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Review from Chapter 6:  A tax is a wedge between the price buyers pay and the price sellers receive.  A tax raises the price buyers pay and lowers the price sellers receive, a tax on the “transaction”.  A tax reduces the quantity bought & sold.  These effects are the same whether the tax is imposed on buyers or sellers, so we do not make this distinction in this chapter.

5 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Reviewing Tax Incidence from Ch. 6  The government can impose the tax on either the buyer or seller, which defines the “statutory incidence.”  A tax on the buyer creates a ‘demand curve’ (payments received) as perceived by sellers that is below the market demand curve (buyers pay).  A tax on the seller is an increase in sellers’ costs, shifting the supply curve up by the amount of the tax.  The new equilibrium and the tax incidence is the same in both instances!

6 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION S1S1 D1D1 $ A Tax on Buyers A tax on buyers shifts the D curve showing payments to the seller down by the tax amount. P Q D2D2 $11.00 P B = $9.50 P S = Tax Effects of a $1.50 per unit tax on buyers The price buyers pay rises, the price sellers receive falls.

7 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION S1S1 A Tax on Sellers A tax on sellers shifts the S curve up by the amount of the tax. P Q D1D1 $ S2S2 430 $11.00 P B = $9.50 P S = Tax Effects of a $1.50 per unit tax on sellers The price buyers pay rises, the price sellers receive falls, eq’m Q falls.

8 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION QTQT The Effects of a Tax P Q D S With no tax, eq’m price is P E and quantity is Q E. PSPS PBPB PEPE QEQE Govt imposes a tax of $T per unit. the price sellers receive is P S, and quantity is Q T. The price buyers pay is P B, Size of tax = $T

9 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION The Effects of a Tax P Q D S The tax generates revenue equal to $ T x Q T. PSPS PBPB PEPE QEQE QTQT Size of tax = $T

10 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION The Effects of a Tax on Efficiency  Next, we use the tools of welfare economics to measure the gains and losses from a tax.  We will determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax.  Tax revenue is included in total surplus, because tax revenue can be used to provide services such as roads, police, public education, etc.  * Efficiency effects ignore equity/fairness issue!

11 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Total Surplus Without a Tax P Q D S Without a tax, PEPE QEQE QTQT A B C D E F CS = A + B + C PS = D + E + F Tax revenue = 0 Total surplus = CS + PS = A + B + C + D + E + F

12 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION The Effects of a Tax P Q D S PSPS PBPB QEQE QTQT A B C D E F CS = A PS = F Tax revenue = B + D Total surplus = A + B + D + F With the tax, The tax causes total surplus to fall by C + E

13 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION The Effects of a Tax P Q D S PSPS PBPB QEQE QTQT A B C D E F C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax.

14 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION About the Deadweight Loss P Q D S PSPS PBPB QEQE QTQT Because of the tax, the units between Q T and Q E are not sold. The value of these units to buyers is greater than the cost of producing them, so the tax has prevented some mutually beneficial trades.

A C T I V E L E A R N I N G 1 : Analysis of tax 15 A. Compute CS, PS, and total surplus without a tax. B. If $100 tax per ticket, compute CS, PS, tax revenue, total surplus, and DWL. D S P Q $ The market for airplane tickets

A C T I V E L E A R N I N G 1 : Answers to A 16 D S CS = ½ x $200 x 100 = $10,000 P Q $ total surplus = $10,000 + $10,000 = $20,000 PS = ½ x $200 x 100 = $10,000 P = The market for airplane tickets

A C T I V E L E A R N I N G 1 : Answers to B 17 D S CS = ½ x $150 x 75 = $5,625 P Q $ total surplus = $18,750 PS = $5,625 tax revenue = $100 x 75 = $7,500 DWL = $1,250 P S = P B = A $100 tax on airplane tickets

18 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION What Determines the Size of the DWL?  To minimize efficiency losses, governments seek to tax the goods or services with the smallest DWL.  So when is the DWL small vs. large? ANSWER: DWL is LEAST WHEN QUANTITY CHANGES ARE THE LEAST!  Recall: The price elasticity of demand (or supply) measures how much quantity demanded (or supplied) changes when the price changes. Hence, DWL depends on the elasticities of supply and demand.

19 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION the DWL of a tax is small. When supply is inelastic, DWL and the Elasticity of Supply P Q D S Size of tax

20 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION the larger is the DWL. DWL and the Elasticity of Supply The more elastic is supply, P Q D S Size of tax

21 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION the DWL of a tax is small. DWL and the Elasticity of Demand When demand is inelastic, P Q D S Size of tax

22 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION the larger is the DWL. DWL and the Elasticity of Demand P Q D S Size of tax The more elastic is demand,

23 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Why Elasticity Affects the Size of DWL  A tax distorts the market outcome: consumers buy less and producers sell less, so eq’m Q is below the surplus-maximizing quantity.  Dead Weight Loss is LARGEST when large changes in quantities occur – i.e. the amount of transactions is altered the MOST.  Elasticity measures how much buyers and sellers respond to changes in price, and therefore determines how much the tax distorts the market outcome.

A C T I V E L E A R N I N G 2 : Elasticity and DWL of a tax Would the DWL of a tax be larger if the tax were on A. Rice Krispies or sunscreen? B. Hotel rooms in the short run or hotel rooms in the long run? C. Groceries or meals at fancy restaurants? 24

25 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Answers: Depends on elasticities  Rice Krispies has substitutes, hence demand more elastic, hence DWL larger on Rice Krispies tax. The tax on insulin hardly alters quantity bought, hence little DWL!  DWL is larger in the long run as supply and demand elasticities are larger, leading to larger quantity changes in the long run.  Groceries are a necessity, with inelastic demand, hence grocery tax has smaller DWL than a tax on fancy meals!

26 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION The Effects of Changing the Size of the Tax  Policymakers often change taxes, raising some and lowering others.  What happens to DWL and tax revenue when taxes change? We explore this next….  The answer will be that larger taxes cause a larger dead weight loss. An important implication is that broad tax bases which impose a low tax rate on many goods results in smaller dead weight loss than imposing much higher taxes on just a few items. Tax reform usually involves broadening the tax base.

27 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Q2Q2 Q1Q1 DWL and the Size of the Tax P Q D S causes the DWL to more than double. Doubling the tax 2T2T T Initially, the tax is T per unit. initial DWL new DWL

28 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Q3Q3 DWL and the Size of the Tax P Q D S Q1Q1 3T3T T causes the DWL to more than triple. Tripling the tax Initially, the tax is T per unit. initial DWL new DWL

29 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION DWL and the Size of the Tax DWL Tax size Summary When a tax increases, DWL rises even more. Implication When tax rates are low, raising them doesn’t cause much harm, and lowering them doesn’t bring much benefit. When tax rates are high, raising them is very harmful, and cutting them is very beneficial. Implication When tax rates are low, raising them doesn’t cause much harm, and lowering them doesn’t bring much benefit. When tax rates are high, raising them is very harmful, and cutting them is very beneficial.

30 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Tax Rates and Revenues  How much revenue will we raise if we increase rates?  Can we raise ever more revenue by raising tax rates ever higher?  What limits the amount of revenue the government can raise?  The answers depend on reactions of economic agents, and elasticities of demand and supply.

31 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Q2Q2 Revenue and the Size of the Tax P Q D S Q1Q1 PBPB PSPS PBPB PSPS 2T2T T When the tax is small, increasing it causes tax revenue to rise.

32 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Q3Q3 Revenue and the Size of the Tax P Q D S Q2Q2 PBPB PSPS PBPB PSPS 3T3T 2T2T When the tax is larger, increasing it causes tax revenue to fall.

33 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION The Laffer curve shows the relationship between the size of the tax and tax revenue. This concept was used to argue that high income tax rates would lower revenue as people work less. Revenue and the Size of the Tax Tax size Tax revenue The Laffer curve

34 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION Maryland Tax Policy  Maryland has a high income tax relative to other states, that is a virtually proportional tax. Its sales tax rate has been 5% -- below average.  Maryland’s sales tax is far out of date: it taxes goods but not services. (The tax on car repairs is on the parts purchased but not the labor!)  If Maryland needs more revenue, should it raise the rate by a penny, or “broaden” the tax base by making the tax apply to services? In 2008, Maryland raised the rate to 6% but declined to broaden the base given political opposition.

35 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION How Big Should the Government Be? This discussion of DWL is only one issue relevant to answering this question!  A bigger government provides more services, but requires higher taxes, which cause DWL. The larger the DWL from taxation, the greater the argument for smaller government.  The tax on labor income is especially important; it’s the biggest source of govt revenue. For many workers, the marginal tax rate (the tax on the last dollar of earnings) is almost 50%.  How big is the DWL from taxes on income? It depends on elasticity….

36 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION One viewpoint on labor supply…  If labor supply is inelastic, then this DWL is small.  Some economists believe labor supply is inelastic, arguing that most workers work full time regardless of the wage.  We shall develop a model of labor supply and discuss the elasticity later in the course.

37 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION An alternative view on labor supply … Other economists believe labor taxes are highly distorting because some groups of workers have elastic supply and can respond to incentives: Many workers can adjust their hours, e.g. by working overtime. Many families have a 2 nd earner with discretion over whether and how much to work. Many elderly choose when to retire based on the wage they earn.

38 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION CHAPTER SUMMARY  A tax on a good reduces the welfare of buyers and sellers. This welfare loss usually exceeds the revenue the tax raises for the govt.  The fall in total surplus (consumer surplus, producer surplus, and tax revenue) is called the deadweight loss (DWL) of the tax.  A tax has a DWL because it causes consumers to buy less and producers to sell less, thus shrinking the market below the level that maximizes total surplus.

39 CHAPTER 8 APPLICATION: THE COSTS OF TAXATION CHAPTER SUMMARY  The price elasticities of demand and supply measure how much buyers and sellers respond to price changes. Therefore, higher elasticities imply higher DWLs.  An increase in the size of a tax causes the DWL to rise even more.  An increase in the size of a tax causes revenue to rise at first, but eventually revenue falls because the tax reduces the size of the market.