1. Application: The Costs of Taxation

2. Deadweight Loss of Taxation
Tax on a good
Levied on buyers
Demand curve shifts downward by the size of tax
Levied on sellers
Supply curve shifts upward by the size of tax
Same outcome: price wedge
Price paid by buyers rises
Price received by sellers falls
Lower quantity sold

3. Deadweight Loss of Taxation
Tax burden
Distributed between producers and consumers
Determined by elasticities of supply and demand
Market for the good becomes smaller

4. The effects of a tax
Price
Demand
Price buyers pay
Supply
Quantity
with tax
Size
of tax
Price without tax
Quantity
without tax
Price sellers receive
Quantity
A tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls.

5. The Deadweight Loss of Taxation
How a tax affects market participants
Gains and losses from a tax on a good
Buyers: consumer surplus
Sellers: producer surplus
Government: total tax revenue
Tax times quantity sold
Public benefit from the tax

6. Tax revenue Price Demand Supply Price buyers pay Quantity with tax
Size of tax (T)
Supply
Price buyers pay
Quantity
with tax
Tax
revenue
T ˣ Q
Quantity
without tax
Price sellers receive
Quantity sold (Q)
Quantity
The tax revenue that the government collects equals T × Q, the size of the tax T times the quantity sold Q. Thus, tax revenue equals the area of the rectangle between the supply and demand curves

7. The Deadweight Loss of Taxation
Welfare without a tax
Maximum Consumer Surplus
Maximum Producer Surplus
Total tax revenue = zero
Welfare with tax
Smaller Consumer Surplus
Smaller Producer Surplus
Total tax revenue > zero
Smaller overall welfare

8. How a tax affects welfare
Price
Demand
Price
buyers
pay
=PB Q2
Supply A
A tax on a good reduces consumer surplus (by the area B + C)
The tax reduces producer surplus (by the area D + E).
Because the fall in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a deadweight loss (area C + E). C B
Price
without
tax
=P1 E Q1 D
Price
sellers
receive
=PS F
Quantity
Without Tax
With Tax
Change
Consumer Surplus
Producer Surplus
Tax Revenue
Total Surplus
A+B+C
D+E+F
None
A+B+C+D+E+F A F
B+D
A+B+D+F
-(B+C)
-(D+E)
+(B+D)
-(C+E)
The area C + E shows the fall in total surplus and is the deadweight loss of the tax

9. The Deadweight Loss of Taxation
Losses of surplus to buyers and sellers from a tax exceeds the revenue raised by the government
Deadweight loss: The fall in total surplus that results from a market distortion, such as a tax
Taxes distort incentives
Markets now allocate resources inefficiently

10. How a tax affects welfare
Hamburger Market
Price
Demand
Price
buyers
pay
=$11 90
Supply
Tax ($2 times 90) = $180
C+E = $20
Government revenue increased by $180 but the tax damaged the market by $200
If the government fails to take $180 and create $200 or more in value, then policy lowered overall economic value
$180
$20
Price
without
tax
=$10
100
Price
sellers
receive
=$9
Quantity
Hamburger sellers create a lower price
Hamburger consumers pay a higher price
The hamburger market is now smaller
Even if the government manages to create economic value buyers and sellers in the hamburger market are unlikely to be better off (redistribution of income)

11. Determinants of the Deadweight Loss
Price elasticities of supply and demand
When the supply curve is more elastic
Deadweight loss is larger
When the demand curve is more elastic
The greater the elasticities of supply and demand
The greater the deadweight loss of a tax

12. Tax distortions and elasticities
Inelastic Supply
Elastic Supply
When supply is relatively inelastic, the deadweight loss of a tax is small
Price
Price
When supply is relatively elastic, the deadweight loss of a tax is large
Demand
Supply
Demand
Supply
Size
of tax
Size
of tax
Quantity
Quantity
In the above illustrations the demand curve and the size of the tax are the same, but the price elasticity of supply is different. Notice that the more elastic the supply curve, the larger the deadweight loss of the tax.

13. Tax distortions and elasticities
Inelastic Demand
Elastic Demand
When demand is relatively inelastic, the deadweight loss of a tax is small
When demand is relatively elastic, the deadweight loss of a tax is large
Price
Price
Supply
Supply
Demand
Demand
Size
of tax
Size
of tax
Quantity
Quantity
In the above illustrations, the supply curve and the size of the tax are the same, but the price elasticity of demand is different. Notice that the more elastic the demand curve, the larger the deadweight loss of the tax.

14. The deadweight loss debate
Size of Government
The larger the deadweight loss of taxation
The larger the cost of any government program
If taxes cause a large deadweight losses
Strong argument for a leaner government
Do less and taxes less
If taxes cause a small deadweight losses
Government programs are less costly

15. Deadweight Loss & Tax Revenue
As the tax increases
Deadweight loss increases
Even more rapidly than the size of the tax
Tax revenue
Increases initially
Then decreases
Higher tax – drastically reduces the size of the market

16. Deadweight Loss & Tax Revenue
Small tax
Medium tax
Large tax
Price
Price
Price
Deadweight
loss
Deadweight
loss
Deadweight
loss
Demand
Demand PB
Supply
Supply
Demand Q2
Supply PB Q2 PB
Tax
revenue Q2
Tax
revenue Q1 Q1
Tax revenue Q1 PS PS PS
Quantity
Quantity
Quantity
The deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the amount of the tax times the amount of the good sold. A small tax has a small deadweight loss and raises a small amount of revenue. A somewhat larger tax has a larger deadweight loss and raises a larger amount of revenue. A very large tax has a very large deadweight loss, but because it has reduced the size of the market so much, the tax raises only a small amount of revenue.

17. Deadweight Loss & Tax Revenue
1974, economist Arthur Laffer
Tax rates were so high
Reducing them would actually raise tax revenue
Ronald Reagan ran for president in 1980
Taxes were so high that they were discouraging hard work
Lower taxes would give people the proper incentive to work
Raise economic well-being
Perhaps increase tax revenue

18. Deadweight Loss & Tax Revenue
Tax size
Laffer curve
Tax revenue first increases
then decreases