2 Deadweight Loss of Taxation Tax on a goodLevied on buyersDemand curve shifts downward by the size of taxLevied on sellersSupply curve shifts upward by the size of taxSame outcome: price wedgePrice paid by buyers risesPrice received by sellers fallsLower quantity sold
3 Deadweight Loss of Taxation Tax burdenDistributed between producers and consumersDetermined by elasticities of supply and demandMarket for the good becomes smaller
4 The effects of a taxPriceDemandPrice buyers paySupplyQuantitywith taxSizeof taxPrice without taxQuantitywithout taxPrice sellers receiveQuantityA 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 participantsGains and losses from a tax on a goodBuyers: consumer surplusSellers: producer surplusGovernment: total tax revenueTax times quantity soldPublic benefit from the tax
6 Tax revenue Price Demand Supply Price buyers pay Quantity with tax Size of tax (T)SupplyPrice buyers payQuantitywith taxTaxrevenueT ˣ QQuantitywithout taxPrice sellers receiveQuantity sold (Q)QuantityThe 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 taxMaximum Consumer SurplusMaximum Producer SurplusTotal tax revenue = zeroWelfare with taxSmaller Consumer SurplusSmaller Producer SurplusTotal tax revenue > zeroSmaller overall welfare
8 How a tax affects welfare PriceDemandPricebuyerspay=PBQ2SupplyAA 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).CBPricewithouttax=P1EQ1DPricesellersreceive=PSFQuantityWithout TaxWith TaxChangeConsumer SurplusProducer SurplusTax RevenueTotal SurplusA+B+CD+E+FNoneA+B+C+D+E+FAFB+DA+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 governmentDeadweight loss: The fall in total surplus that results from a market distortion, such as a taxTaxes distort incentivesMarkets now allocate resources inefficiently
10 How a tax affects welfare Hamburger MarketPriceDemandPricebuyerspay=$1190SupplyTax ($2 times 90) = $180C+E = $20Government revenue increased by $180 but the tax damaged the market by $200If the government fails to take $180 and create $200 or more in value, then policy lowered overall economic value$180$20Pricewithouttax=$10100Pricesellersreceive=$9QuantityHamburger sellers create a lower priceHamburger consumers pay a higher priceThe hamburger market is now smallerEven 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 demandWhen the supply curve is more elasticDeadweight loss is largerWhen the demand curve is more elasticThe greater the elasticities of supply and demandThe greater the deadweight loss of a tax
12 Tax distortions and elasticities Inelastic SupplyElastic SupplyWhen supply is relatively inelastic, the deadweight loss of a tax is smallPricePriceWhen supply is relatively elastic, the deadweight loss of a tax is largeDemandSupplyDemandSupplySizeof taxSizeof taxQuantityQuantityIn 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 DemandElastic DemandWhen demand is relatively inelastic, the deadweight loss of a tax is smallWhen demand is relatively elastic, the deadweight loss of a tax is largePricePriceSupplySupplyDemandDemandSizeof taxSizeof taxQuantityQuantityIn 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 GovernmentThe larger the deadweight loss of taxationThe larger the cost of any government programIf taxes cause a large deadweight lossesStrong argument for a leaner governmentDo less and taxes lessIf taxes cause a small deadweight lossesGovernment programs are less costly
15 Deadweight Loss & Tax Revenue As the tax increasesDeadweight loss increasesEven more rapidly than the size of the taxTax revenueIncreases initiallyThen decreasesHigher tax – drastically reduces the size of the market
16 Deadweight Loss & Tax Revenue Small taxMedium taxLarge taxPricePricePriceDeadweightlossDeadweightlossDeadweightlossDemandDemandPBSupplySupplyDemandQ2SupplyPBQ2PBTaxrevenueQ2TaxrevenueQ1Q1Tax revenueQ1PSPSPSQuantityQuantityQuantityThe 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 LafferTax rates were so highReducing them would actually raise tax revenueRonald Reagan ran for president in 1980Taxes were so high that they were discouraging hard workLower taxes would give people the proper incentive to workRaise economic well-beingPerhaps increase tax revenue
18 Deadweight Loss & Tax Revenue Tax sizeLaffer curveTax revenue first increasesthen decreases