1. Copyright © 2004 South-Western/Thomson Learning Application: The Costs of Taxation Recall that welfare economicsRecall that welfare economics is the study of how the allocation of resources affects economic well- being. Buyers and sellers receive benefits from taking part in the market (CS & PS). The competitive market equilibrium outcome maximizes the total well-being of buyers and sellers.

2. Copyright © 2004 South-Western/Thomson Learning THE DEADWEIGHT LOSS OF TAXATION How do taxes affect the economic well-being of market participants? When a tax is levied in a market…. The price paid by buyers rises and the price received by sellers falls.

3. Copyright © 2004 South-Western/Thomson Learning How a Tax Affects Market Participants A tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge, the quantity of units bought and sold falls below the amount that would be bought and sold without a tax (equilibrium). The size of the market for the taxed good shrinks.

4. Copyright © 2004 South-Western/Thomson Learning How a Tax Affects Market Participants The change in total welfare includes: The change in consumer surplus and producer surplus The tax revenue. Loss in CS and PS exceeds the tax revenue raised. This drop in net well-being to society is called deadweight loss (DWL). DWL arises because buyers and sellers no longer realize some of the gains from trade compared to the competitive market equilibrium outcome (some units are no longer traded).

5. Figure 4 The Deadweight Loss Copyright © 2004 South-Western Cost to sellers Value to buyers Size of tax Quantity 0 Price Demand Supply Lost gains from trade Reduction in quantity due to the tax Price without tax Q1Q1 PBPB Q2Q2 PSPS

6. Copyright © 2004 South-Western/Thomson Learning DETERMINANTS OF THE DEADWEIGHT LOSS What determines whether the DWL and the tax revenue from a tax are large or small? The amounts of DWL and tax revenue depend on how much the quantity supplied and quantity demanded respond to changes in the price. price elasticitiesIn other words, the amounts of DWL and tax revenue depend on the price elasticities of supply and demand.

7. Copyright © 2004 South-Western/Thomson Learning DETERMINANTS OF THE DEADWEIGHT LOSS More elastic demand and supply results in… Larger decline in equilibrium quantity. Greater DWL. Smaller tax revenue.

8. Copyright © 2004 South-Western/Thomson Learning Summary A tax on a good reduces the well-being of buyers and sellers of the good. The reduction in consumer surplus and producer surplus usually exceeds the tax revenue raised. This drop in net well-being is referred to as the deadweight loss (DWL) of the tax.

9. Copyright © 2004 South-Western/Thomson Learning Summary Taxes generally have a DWL because they cause buyers to consume less and sellers to produce less. This change in behavior shrinks the size of the market below the competitive market equilibrium outcome which maximizes total well-being.

10. Copyright © 2004 South-Western/Thomson Learning Summary DWL is the cost of raising revenue from taxing a particular good or service (no free lunch). It is more efficient to raise revenue by taxing markets with inelastic demand and/or supply. You should always ask: What does policy success require and what does reality look like?