The costs of taxation

Tax Usually taxes are collected because government wants to run the country. Some people believe that all taxation creates market distortion and results in economic inefficiency.

Cause and effect When there is a tax, then a deadweight loss is created? What is a deadweight loss? Where the total surplus decrease due to the presence of market distortion.

Deadweight loss There is no difference whether a tax on a good is levied on buyers or sellers of the good. The price paid by buyers rises, and the price received by sellers becomes less.

Who is better off? Size of tax Quantity 0 Price Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax By looking at the graph we notice that C+E is the tax revenue. Originally the consumer surplus is A+B+C. However, after the presence of tax, the consumer surplus decreases by -(B+C). A B C D E F Also the total surplus decreases by -(C+E) because C+E represents the deadweight loss.

Who is better off deadweight losses occurs when taxes are in presence, because they protect buyers and sellers from realizing some of the gains from trade.

How does tax affect the market? When there is a tax, the tax creates something called a wedge between the buyers and sellers. The size of the market for that good shrinks.

Tax revenue Despite the fact that when there is a tax the consumer, producer and total surplus all fall. A tax revenue is created. How to calculate the tax revenue Tax Revenue T = the size of the tax Q = the quantity of the good sold T  Q = the government’s tax revenue T  Q = the government’s tax revenue

Where is the tax revenue? Size of tax Quantity 0 Price Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax A B C D E F B+D= Tax revenue

Deadweight loss differs Depending whether the supply or demand curve is elastic or inelastic. If it is elastic the deadweight loss is extremely huge if it is inelastic the deadweight loss is small

Inelastic supply curve Price 0Quantity Demand Supply Size of tax When supply is relatively inelastic, the deadweight loss of a tax is small

When Supply curve is elastic (b) Elastic Supply Price 0 Quantity Demand Supply Size of tax When supply is relatively elastic, the deadweight loss of a tax is large

Wait a second If the tax gradually increases would the tax revenue always gradually increase? NO!! If the size of the tax continues to rise, tax revenue falls because the higher tax reduces the size of the market.

What is the laffer curve? When the tax increases, the deadweight loss also gets larger as well. By contrast, tax revenue first rises with the size of a tax, but then as the tax gets larger, the market shrinks so much that tax revenue starts to fall. (Laffer curve)

Laffer curve The Laffer curve depicts the relationship between tax rates and tax revenue. The laffer curve represents the relationship between the tax revenue and the tax rate.

Summary When a tax is in presence there is a fall in consumer,producer and total surplus. When a tax is in presence a deadweight loss occurs.

Summary Depending on whether the supply or demand curve is elastic or inelastic, the deadweight loss differs. Tax revenue first rises as the tax is presence Unfortunately, a larger tax reduces the tax revenue, it reduces the market size.

Review questions What does the laffer curve represent What is a deadweight loss How does tax effect the market, explain

Answers The laffer curve represents the relationship between the tax revenue and the tax rate. There is no difference whether a tax on a good is levied on buyers or sellers of the good. The price paid by buyers rises, and the price received by sellers becomes less. When there is a tax, the tax creates something called a wedge between the buyers and sellers. The size of the market for that good shrinks.