Chapter 8 The Costs of Taxation Ratna K. Shrestha

Overview  The Deadweight Loss of Taxation  The Determinants of Deadweight Loss  The Relation Between Deadweight Loss and Tax Revenue as Taxes Vary  How does the application of a tax affect the market system?

Market Efficiency  The economic well-being of a society is measured as the sum of consumer surplus and producer surplus.  Market Efficiency is attained when total surplus is maximized,  In a perfectly competitive market, total surplus is maximized at a point where Supply = Demand.

Market Efficiency without Taxation S D PEPE Consumer Surplus Producer Surplus Q P

Taxes! Taxes! Taxes!  Who pays the tax on a good? The buyer or the seller?  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.

The Effects of Tax Copyright © 2004 South-Western Tax revenue (T × Q) Size of tax (T ) Quantity sold (Q) Quantity 0 Price Demand Supply Quantity without tax Quantity with tax Price buyers pay Price sellers receive It does not matter which side of the market (D or S) the tax is imposed.

The Deadweight Loss of Taxation  A tax places a wedge between the price buyers pay and the price sellers receive.  It results in a Deadweight Loss, the loss in consumer and producer surplus combined. Tax! P Q D S PbPb PsPs Loss! Q tax Q no tax

Deadweight Loss of Taxation  When a tax is levied on buyers, the demand curve shifts (vertical shift) downward by the size of the tax.  When a tax is levied on sellers, the supply curve shifts upward by that amount.  The losses to buyers and sellers exceed the tax revenue raised by the government, leading to a Deadweight Loss.

Deadweight Loss of Taxation: Example  On the graph (next slide), the current market situation of P = $0.50 per unit of a product results in 1,000 units being offered for sale and purchased.  Suppose a twenty cent tax per quantity ($0.20/quantity) is imposed on the suppliers. Sellers “collect” the tax and send the tax revenue to the government.

Deadweight Loss of Taxation $ Demand Supply P Q

Deadweight Loss of Taxation $ Demand Supply $.60 $ $.20 tax imposed P Q A B C D E F

Deadweight Loss of Taxation: Example  The twenty cent tax (per quantity) results in new prices to consumers and producers: –Consumers pay $0.60 –Sellers receive $0.40 (= $0.6 – 0.2)  The Tax Revenue from the imposed tax is = $0.2 x 800 = $160.  The loss in quantity demanded and the quantity supplied is 200 units (= ).

Deadweight Loss of Taxation $ Demand Supply $.60 $ Tax Revenue P Q

Changes in Welfare from a Tax Without TaxWith TaxChange CS A+B+CA- (B+C) PS D+E+FF- (D+E) Tax Revenue NoneB+D+ (B+D) Total Surplus A+B+C+ D+E+F A+B+D+F- (C+E) See slide #11

Deadweight Loss of Taxation $ Demand Supply $.60 $ Loss in Quantity P Q

Deadweight Loss of Taxation $ Demand Supply $.60 $ Deadweight Loss = $20 Q P

Deadweight Loss of Taxation: Example  The value of the loss to society due to the twenty cent tax = $20 (1/2 x0.2x 200). This loss is called deadweight loss.  Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade (next graph).  Tax results in Q 2 amount being sold and purchased. Although, the value of one more unit of Q (beyond Q 2 ) is higher to the consumer than its cost of production (MC), this production is not realized.

Why Taxes Cause Deadweight Loss? Copyright © 2004 South-Western Cost to sellers Value to buyers Size of tax Quantity 0 Price Demand Supply Lost gains from trade Reduction in quantity due to the tax Price without tax Q1Q1 PBPB Q2Q2 PSPS

Determinants of Deadweight Loss  The magnitude of the Deadweight Loss (DWL) depends upon how large a decline in market exchange (decline in Q) occurs as a result of the tax. In the previous example, the decrease in Q = Q 1 - Q 2  The size in the decline in market exchange depends upon how sensitive consumers and producers are to changes in prices: that is the Elasticity of Supply and Demand.  The more elastic demand and supply are, the greater will be the decline in equilibrium quantity and the greater the DWL.

More Elastic Demand and Supply S0S0 D0D0 QEQE PEPE

S0S0 D0D0 QEQE PEPE S2S2 Amount of Tax Q2Q2 P2P2

More Elastic Demand and Supply S0S0 D0D0 QEQE PEPE S2S2 Amount of Tax Q2Q2 P2P2 Deadweight Loss! P1P1

Determinants of Deadweight Loss  A tax causes a deadweight loss because it induces buyers and sellers to change their behavior. –Higher prices (P 2 ) cause buyers to buy less. –Lower prices (P 1 ) received causes sellers to offer less.  This market distortion (decline in equilibrium Q) caused by taxes increases with the elasticity of supply and demand.

Less Elastic Demand and Supply S0S0 D0D0 QEQE PEPE

S0S0 D0D0 QEQE PEPE S2S2 P2P2 Q2Q2 Amount of Tax Deadweight Loss! P1P1

Deadweight Loss and Tax Revenue  The deadweight loss of a tax rises more rapidly than the tax rate. –If we double the tax rate, the area of the triangle hence deadweight loss increases four times.  With each increase in the tax rate, tax revenues will rise slowly, reach a maximum, and then decline (Laffer Curve).  In 1974, A. Laffer suggested that the US economy was in the downward sloping portion of the Laffer Curve.

Deadweight Loss and Tax Revenue PSPS Q1Q1 Demand Supply PBPB Q2Q2 Q P Tax Revenue Deadweight Loss A small tax causes a small deadweight loss and raises a small revenue

Deadweight Loss and Tax Revenue PSPS Q1Q1 Demand Supply PBPB Q2Q2 Q P Tax Revenue Deadweight Loss A larger tax causes a larger deadweight loss and raises a larger revenue

Deadweight Loss and Tax Revenue PSPS Q1Q1 Demand SupplyPBPB Q2Q2 Q P Tax Revenue Deadweight Loss A very large tax has a very large deadweight loss but may in fact reduce the revenue.

Tax Size Vs. Revenue and DWL Tax Size Deadweight Loss $ Revenue (Laffer Curve)

Case Study:Deadweight Loss Debate  How big should the government be?  The larger the deadweight loss of taxation, the larger the cost of any government program.  The most important tax on Canadian economy is tax on labor  Economists disagree on the size of deadweight loss caused by labor taxation. Those who believe labor tax is highly distorting argue that……  Many workers can adjust the number of hours they work. Higher the net wage, the more overtime hours they choose to work.

Case Study:Deadweight Loss Debate  Labor tax affects the decision of the second earners (usually married women with children) to work.  Many retires decision to work also depends on net wage rate.  Higher labor tax encourages jobs that pays “cash under the table.”  When two political candidates debate on whether to reduce tax, a part of the disagreement lies on the different views about elasticity of labor supply.

Costs of Taxation: Conclusion  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.  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.

Costs of Taxation: Conclusion  As the tax rate gets larger, the deadweight loss increases more proportionately than the tax increase.  With the increase in the tax rate, the percentage decrease in market equilibrium quantity becomes greater. As a result, tax revenues begin to decrease after some point.