Chapter 8 Application: The Costs of Taxation. Review of Taxes Taxes raise revenue for gov’t & it comes out of someone’s pocket Both buyers & sellers are.

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Presentation transcript:

Chapter 8 Application: The Costs of Taxation

Review of Taxes Taxes raise revenue for gov’t & it comes out of someone’s pocket Both buyers & sellers are worse off when a good is taxed Need to compare the reduced welfare of buyers and sellers to the amount of revenue the government raises

Deadweight Loss of Taxation Welfare without a Tax Entire area in red & blue is total surplus Welfare is maximized

Changes in Welfare with a Tax The losses to buyers and sellers from a tax exceed the revenue raised by the government This fall in total surplus is called Deadweight Loss Taxes distort incentives & cause markets to allocate resources inefficiently

Deadweight Loss Taxes cause DWL because they prevent buyers & sellers from realizing some of the gains from trade

Determinants of Deadweight Loss Greater elasticities yield greater DWL

DWL and Tax Revenue as Taxes Vary As tax gets larger, DWL quickly increases As tax gets larger, tax revenue first rises then starts to fall eventually Extreme case shown in Laffer Curve