Presentation on theme: "Application: The Costs of Taxation"— Presentation transcript:
1 Application: The Costs of Taxation 8Application: The Costs of Taxation
2 The 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 The Deadweight Loss of Taxation Tax burdenDistributed between producers and consumersDetermined by elasticities of supply and demandMarket for the good - smaller
4 1 The effects of a tax Price Demand Price buyers pay Supply Quantity with 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 2 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 taxConsumer surplusProducer surplusTotal tax revenue = 0Welfare with taxSmaller consumer surplusSmaller producer surplusTotal tax revenueSmaller overall welfare
8 How a tax affects welfare 3How a tax affects welfarePriceDemandPricebuyerspay=PBSupplyAA tax on a good reduces consumer surplus (by the area B + C) and 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).Q2CBPricewithouttax=P1EQ1DPricesellersreceive=PSFQuantityThe area C + E shows the fall in total surplus and is the deadweight loss of the taxWithout 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)
9 The Deadweight Loss of Taxation Losses of surplus to buyers and sellers from a taxExceed the revenue raised by the governmentDeadweight lossFall in total surplus that results from a market distortion, such as a taxTaxes distort incentivesMarkets allocate resources inefficiently
10 The Deadweight Loss of Taxation Deadweight losses and the gains from tradeTaxes cause deadweight lossesPrevent buyers and sellers from realizing some of the gains from tradeThe gains from tradeDifference between buyers’ value and sellers’ costLess than the taxOnce the tax is imposedTrades are not madeDeadweight loss
11 4 The deadweight loss Price Demand Supply PB Q2 Value to buyers Price Lost gainsfrom tradePBSizeof taxQ2Value tobuyersPricewithout taxQ1Cost tosellersPSQuantityReduction in quantity due to the taxWhen the government imposes a tax on a good, the quantity sold falls from Q1 to Q2. At every quantity between Q1 and Q2, the potential gains from trade among buyers and sellers are not realized. These lost gains from trade create the deadweight loss.
12 Determinants of the Deadweight Loss Price elasticities of supply and demandSupply curve - more elasticDeadweight loss – largerDemand curve – more elasticThe greater the elasticities of supply and demandThe greater the deadweight loss of a tax
13 Tax distortions and elasticities (a, b) 5Tax distortions and elasticities (a, b)(a) Inelastic supply(b) Elastic 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 panels (a) and (b), 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.
14 Tax distortions and elasticities (c, d) 5Tax distortions and elasticities (c, d)(c) Inelastic demand(d) Elastic 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 panels (c) and (d), 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.
15 Deadweight Loss & Tax Revenue as Taxes Vary 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 6How deadweight loss and tax revenue vary with the size of a tax (a, b, c)(a) Small tax(b) Medium tax(c) Large taxPricePricePriceDeadweightlossDeadweightlossDeadweightlossDemandDemandPBDemandSupplySupplyQ2SupplyPBQ2PBTaxrevenueQ2TaxrevenueQ1Q1Tax 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. In panel (a), a small tax has a small deadweight loss and raises a small amount of revenue. In panel (b), a somewhat larger tax has a larger deadweight loss and raises a larger amount of revenue. In panel (c), 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 How deadweight loss and tax revenue vary with the size of a tax (d, e) 6How deadweight loss and tax revenue vary with the size of a tax (d, e)(d) From panel (a) to panel (c),deadweight loss continually increases(e) From panel (a) to panel (c), taxrevenue first increases, then decreasesDeadweightlossTaxRevenueLaffer curveTax sizeTax sizePanels (d) and (e) summarize these conclusions. Panel (d) shows that as the size of a tax grows larger, the deadweight loss grows larger. Panel (e) shows that tax revenue first rises and then falls. This relationship is sometimes called the Laffer curve.
18 The Laffer curve and supply-side economics 1974, economist Arthur LafferLaffer curveSupply-side economicsTax rates were so highReducing them would actually raise tax revenueRonald Reagan - ran for president in 1980From experience in film industryHigh tax rates - caused less workLow tax rates - caused more work
19 The Laffer curve and supply-side economics Ronald Reagan - ran for president in 1980ArgumentTaxes were so high that they were discouraging hard workLower taxes would give people the proper incentive to workRaise economic well-beingPerhaps increase tax revenueEconomists continue to debate Laffer’s argumentGeneral lesson:Change in tax revenue from a tax changeDepends on how the tax change affects people’s behavior