Roadmap: In chapter 6, we used supply and demand tools to determine price and quantity effects of an excise tax. In chapter 7, we developed the tools of consumer and producer surplus to measure welfare effects. Now, in chapter 8, we apply the tools of consumer and producer surplus to see how taxes affect welfare. One important lesson from chapter 6: It doesn’t matter who (buyer or seller) is required to send tax payment to government. The key is that a tax introduces a “wedge” between buyers’ and sellers’ prices.

Consider the market for a good: Demand Supply ($/unit) (units/day) tax wedge = t $/unit The tax introduces a “tax wedge.” Q t Quantity decreases to Q t. The government collects tax revenue = t x Q t $/day. p* Q* Before tax goes into effect, we have equilibrium: p*, Q* pbpb Buyers’ price increases to p b. p s Sellers’ price decreases to p s.

Now let’s look at the welfare effects of the t $/unit tax. A B C D E F w/o tax w. tax change Cons. surplus Prod. surplus Tax rev. Tot. surplus A + B + C D + E + F 0 A + B + C + D + E + F A F B + D A + B + D + F - (B + C) - (D + E) + (B + D) - (C + E) The reduction in total surplus that results from the tax (C + E) is called the tax’s “deadweight loss.” Demand Supply ($/unit) (units/day) pbpb p s p* Q* Q t

Why does the excise tax result in a deadweight loss? The tax “blocks” trade of all units between Q t and Q*. These are units for which the demand price (WTP for the marginal buyer) exceeds the supply price (opportunity cost for the marginal seller). Each of these units could be traded (at some “split-the- difference” price) yielding gains for buyer and seller. Because these units are not traded, some potential surplus is lost.

Let’s look at an example with some numbers. Equilibrium quantity is 100 units/day but For the 80th unit, demand price (WTP for marg. buyer) is $ and supply price (opp. cost for marg. seller) is $1.25. Without tax, mutually beneficial trade of this unit is possible. With tax, the trade is “blocked,” and some potential surplus is lost. Demand Supply ($/unit) 100 (units/day) Consider one of the units for which trade is “blocked” by the tax -- the 80th, say an excise tax of 1.00 $/unit reduces quantity to 60 units/day.

Start with supply and demand again. Consider tax wedges of two different sizes. A bigger tax wedge means a bigger deadweight loss. In fact, the magnitude of the deadweight loss increases faster than proportionately, as the tax wedge increases. ($/unit) (units/day) Demand Supply

For a tax wedge of a given size, how is the size of deadweight loss affected by supply elasticity? ($/unit) (units/day) Demand S1S1 ($/unit) (units/day) Demand A tax wedge results in a deadweight loss. Now consider exactly the same demand... S2S2... but with a more elastic supply. Exactly the same tax wedge results in a bigger deadweight loss.

For a given size of the tax wedge (that is, for a given $/unit amount of the excise tax) and a given demand elasticity deadweight loss is greater the more elastic is supply. Likewise, for a given size of the tax wedge and a given supply elasticity deadweight loss is greater the more elastic is demand. (You do the graphs for that case.)

Total tax revenue and the dollar-per-unit size of the excise tax. D S D S D S With a “small” tax wedge... tax revenue is “small.” With a bigger tax wedge... tax revenue is bigger. With a still bigger tax wedge tax revenue is “small” again.

Graphing tax revenue as a function of excise tax size: tax revenue ($/month) tax size ($/unit) When the tax becomes sufficiently large, people stop buying and selling the good completely. Tax revenue goes to zero.

Application: Arthur Laffer, President Ronald Reagan, federal income tax, and “supply-side economics” (... also known as “Voodoo economics,” according to 1980 presidential candidate, George Bush.) ( The federal income tax is, to a large extent, a tax on labor. It introduces a “tax wedge” between supply and demand in the labor market.

In the context of the federal income tax, reinterpret “tax size” as... marginal tax rate: the extra taxes paid on an additional dollar of income. “Tax revenue” corresponds to the total amount collected by the IRS in federal income tax. For this application: A new version of the tax-revenue vs. tax size graph, called the “Laffer curve.”

federal income tax revenue ($/year) marginal income tax rate (%) Laffer curve Things aren’t quite as simple as this picture implies. In reality: -- there are lots of marginal tax rates (chpt. 12) -- the precise shape and location of curve depends on supply and demand elasticities in lots of labor markets.

But the general nature of the relationship does suggest one very intriguing possibility: income tax rev. ($/year) marginal income tax rate (%) If our economy were currently located to the right of the Laffer curve’s peak then a decrease in marginal tax rates would actually increase (!) federal income tax revenue.

How could this be? With a decrease in marginal tax rates, workers would keep more of every dollar earned. This would induce them to supply more labor. (That’s why it’s called “supply-side economics.”) ( More labor supplied, means more labor income, and more dollars for the IRS to tax. Even though each dollar of income is taxed at a lower rate, there would be more tax revenue collected.

Sounds great! in theory. The critical question: Where is the economy located in relation to the Laffer curve’s peak? In the mid- to late-70s, Arthur Laffer said we were to the right of the peak. Most economists disagreed. Ronald Reagan believed him.

President Reagan’s tax cuts led to significant decreases in federal income tax revenue and contributed to significant federal government deficits throughout the Reagan administration. Experience shows that the economy actually was “to the left” of the Laffer curve’s peak. Where is Arthur Laffer today? He’s all over the internet on “Speaker Bureau” websites.

“Dr. Laffer’s economic acumen and influence in triggering a worldwide tax-cutting movement have earned him the distinction in many publications as “The Father of Supply-Side Economics.” ( “Dr. Arthur Laffer, one of the most distinguished economists of our time, was named as one of the “55 People Who Most Influenced Business in this Century” by the Wall Street Journal.” ( Also: Speaking fee:$32,500 plus expenses