1. Excess Burden and Deadweight Loss Anderson: Efficiency Effects of Taxes and Subsidies

2. Copyright © by Houghton Mifflin Company. All rights reserved. 2 Introduction Taxes and subsidies can cause inefficiencies or correct for inefficiencies in the market. In this chapter we learn how to analyze taxes and subsidies for their efficiency effects.

3. Copyright © by Houghton Mifflin Company. All rights reserved. 3 Excess Burden of Taxes and Subsidies Whenever a tax is placed on a good, service, or form of income, people in the economy are burdened. Not only do they have to pay the tax, which is the first form of burden, but they also are induced to change their behavior as a result of the tax. That change of behavior causes a second form of burden that we call the excess burden of the tax.

4. Copyright © by Houghton Mifflin Company. All rights reserved. 4 Excess Burden The excess burden of a tax refers to the welfare loss caused by imposition of the tax, over and above the revenue the tax generates. In this chapter we consider the causes of excess burden and consider ways to minimize the size of excess burdens resulting from taxation.

5. Copyright © by Houghton Mifflin Company. All rights reserved. 5 Excess Burden With Demand Curves The simplest way to show excess burden is with a demand curve, Although a special type of demand curve is needed called a compensated demand curve. This type of demand curve takes out the income effects of price changes and only shows the substitution effects.

6. Copyright © by Houghton Mifflin Company. All rights reserved. 6 Figure 10.1: Ordinary and Compensated Demand

7. Copyright © by Houghton Mifflin Company. All rights reserved. 7 Figure 10.2: Excess Burden of a Tax

8. Copyright © by Houghton Mifflin Company. All rights reserved. 8 Excess Burden Formula

9. Copyright © by Houghton Mifflin Company. All rights reserved. 9 Figure 10.3: Excess Burden When Tax Is Doubled

10. Copyright © by Houghton Mifflin Company. All rights reserved. 10 Marginal Excess Burden It is important to consider how the excess burden of a tax changes when there is a change in the tax rate. This concept is known as the marginal excess burden (MEB) of a tax.

11. Copyright © by Houghton Mifflin Company. All rights reserved. 11 Figure 10.4: Marginal Excess Burden of a Tax Increase

12. Copyright © by Houghton Mifflin Company. All rights reserved. 12 Excess Burden of a Subsidy Subsidies also create excess burden. The excess burden is the cost of the subsidy in excess of the welfare improvement created by the subsidy.

13. Copyright © by Houghton Mifflin Company. All rights reserved. 13 Figure 10.5: Excess Burden of a Subsidy

14. Copyright © by Houghton Mifflin Company. All rights reserved. 14 Adding the Supply Side to the Story So far, we have assumed that the supply curve is perfectly elastic (horizontal). If we assume that the supply curve is upward sloping, we can generalize the formula for excess burden. Assuming that the elasticity of supply is denoted  x we can write the generalized excess burden formula as follows:

15. Copyright © by Houghton Mifflin Company. All rights reserved. 15 Figure 10.6: Excess Burden With Upward Sloping Supply

16. Copyright © by Houghton Mifflin Company. All rights reserved. 16

17. Copyright © by Houghton Mifflin Company. All rights reserved. 17 Generalized Excess Burden Formula

18. Copyright © by Houghton Mifflin Company. All rights reserved. 18 Generalized Excess Burden Formula [continued] Notice that as the elasticity of supply becomes infinite, the generalized formula collapses to the simple formula first presented. Also notice that excess burden is directly related to both elasticities. The larger the elasticity of demand or supply, the larger the excess burden.

19. Copyright © by Houghton Mifflin Company. All rights reserved. 19 The Special Cases of Inelastic Demand and Supply The generalized excess burden formula also indicates that the smaller the elasticity of demand or supply, the smaller the excess burden of a tax. Consider the cases of zero elasticities of demand and supply in Figure 7.

20. Copyright © by Houghton Mifflin Company. All rights reserved. 20 Figure 10.7: Excess Burden When Demand or Supply is Inelastic

21. Copyright © by Houghton Mifflin Company. All rights reserved. 21 Determinants of Excess Burden From the formula for excess burden, we know its determinants include: Elasticities of demand and supply. Price of the good (which determines quantity). Tax rate applied to the good.