1. Principles of Microeconomics Module 2.4
Taxation

2. Taxes in the Supply and Demand Model
Taxes cause:
Price paid by buyer > Price received by seller
Insert “wedge” in the Supply and Demand model
Tax wedge creates deadweight loss:
Loss of total surplus or economic well-being as a result of the policy

3. Sales Taxes
Taxes insert a wedge between the price paid by buyers (Pb) and price received by sellers (Ps)
Regardless of who pays the tax (sellers or buyers) both share the tax burden
Tax = Pb – Ps
Tax revenue = Tax*Qt
Tax burden (buyer) = Pb – Pe
Tax burden (seller) = Pe - Ps P PB
TAX PS
Qt Qe Q

4. Sales Taxes
Taxes insert a wedge between the price paid by buyers (Pb) and price received by sellers (Ps)
Regardless of who pays the tax (sellers or buyers) both share the tax burden
Tax = Pb – Ps
Tax revenue = Tax*Qt
Tax burden (buyer) = Pb – Pe
Tax burden (seller) = Pe - Ps P PB
TAX PS
Qt Qe Q

5. Sales Taxes
Taxes insert a wedge between the price paid by buyers (Pb) and price received by sellers (Ps)
Regardless of who pays the tax (sellers or buyers) both share the tax burden
Tax = Pb – Ps
Tax revenue = Tax*Qt
Tax burden (buyer) = Pb – Pe
Tax burden (seller) = Pe - Ps P PB
REVENUE
TAX PS
Qt Qe Q

6. Understanding Taxes
Consider the market for socks, where the equilibrium price of socks is $5 per pair and the equilibrium quantity is 300. The government imposes a $1 tax on the market to be paid by the seller, causing a fall in the quantity sold to 200.
What happens when the tax is imposed? Draw out the supply and demand model showing the market before the tax and after the tax

7. Understanding Taxes S P
Pe = $5 D Q
Qe = 300

8. Understanding Taxes S P Pb = $5.50 Tax: Pb – Ps Pe = $5 $1 Pb = $4.50Q
Qt = 200
Qe = 300

9. Understanding Taxes Tax Revenue = Tax*Qt $1 * 200 = $200 S P
Pb = $5.50
Tax:
Pb – Ps $1
Tax Revenue = Tax*Qt
$1 * 200 = $200
Pe = $5
Pb = $4.50 D Q
Qt = 200
Qe = 300

10. Application Reflection
Why does this matter?
It doesn’t matter who pays the tax, both the buyer and seller are burdened when a tax is imposed on the market
Buyers must pay more, sellers must receive a lower price for the same good
Taxes create a distortion in the market because of the mismatch between price paid by the buyer and price received by the seller
Here, the social benefits associated with government spending from the tax revenue (schools, defense, infrastructure ect.) outweigh the economic costs of the tax burden
What’s the most important takeaway?
Taxes create distortions through their impact of prices paid by buyers and received by sellers
Taxes cause: Prices to rise for buyers (pay more) and prices to fall for sellers (receive less) – total Q falls
MUDDIEST POINT?

11. How do taxes affect Market Participants?
Analyze the following before tax vs. after tax is imposed:
Consumer Surplus
Producer Surplus
Total Surplus
Government Revenue
How does the tax change economic welfare?

12. Consumer Surplus BEFORE TAXES AFTER TAXES S S P P Pb Pe Pe Ps D D Q QeQt Q Qe

13. Producer Surplus BEFORE TAXES AFTER TAXES S S P P Pb Pe Pe Ps D D Q QeQt Q Qe

14. Government Tax Revenue
BEFORE TAXES
AFTER TAXES S S P P Pb
Gov’t
Tax
Revenue Pe Pe
Producer
Surplus Ps D D Q Qe Qt Q Qe

15. Deadweight Loss BEFORE TAXES AFTER TAXES S S P P Pb Pe Pe Ps D D Q Qe
DWL
Producer
Surplus Ps D D Q Qe Qt Q Qe

16. Elasticity and the Tax Burden

17. Application 1
Consider the market for paperclips where the equilibrium price is $0.50 and equilibrium quantity is 1000 units. Assume the government imposes a $0.20 tax and we have equal supply and demand price elasticity.
What is the price paid by buyers?
What is the price received by sellers?
What is the tax revenue, assuming Qt = 800?
- Calculate the size of deadweight loss

18. Application 1 continued
Now what if the tax is doubled and the new Qt is 400?
What is the price paid by buyers?
What is the price received by sellers?
What is the tax revenue?
Calculate the size of deadweight loss
What observation can you make regarding tax revenue in both cases?

19. Application Reflection
Why does this matter?
When taxes are imposed, the distortion they cause leads to a decrease in consumer surplus and producer surplus
The larger the tax, the greater the impact it has on lowering CS and PS
But a larger tax also corresponds with a larger tax revenue – government can provide more public goods and services so there is some benefit to it as well.
Depending on the impact on quantity sold of the good – two different tax rates can yield the same tax revenue!
What’s the most important takeaway?
Higher tax and lower tax can yield the same government tax revenue - depending on their impact on quantity sold
Always the higher tax = higher loss in CS and PS
MUDDIEST POINT?

20. Laffer Curve and Tax Revenue
High tax rate is not necessarily better than low tax rate for tax revenue What implication does this have on public policy? Where would be the “optimal tax rate”

21. Key Takeaways
We can think of taxation in the context of supply and demand model in terms of
How it affects prices and quantities
How it affects economic well-being via welfare economics
Since taxes cause distortions in the market (tax wedge) they yield inefficient market outcomes
Why do we have them? Derive some benefits from government revenue.