Applications Taxation-Chap+8

10/21/2015
Application: The Costs of Taxation
Application: The
Costs of Taxation
Welfare economics is the study of how the

allocation of resources affects economic wellbeing.
Buyers and sellers receive benefits from taking part
in the market.
The equilibrium in a market maximizes the total
welfare of buyers and sellers.
Copyright2004 South-Western
Copyright 2004 South-Western/Thomson Learning
THE DEADWEIGHT LOSS OF

TAXATION
How do taxes affect the economic well-being of
market participants?
THE DEADWEIGHT LOSS OF

TAXATION
It does not matter whether a tax on a good is
levied on buyers or sellers
of the good . . . the price
paid by buyers rises, and
the price received by
sellers falls.
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Figure 1 The Effects of a Tax
How a Tax Affects Market Participants

Price
Supply
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
A tax places a wedge between the price buyers

pay and the price sellers receive.
Because of this tax wedge, the quantity sold
falls below the level that would be sold without
a tax.
The size of the market for that good shrinks.
Demand
Quantity
with tax
Quantity
Quantity
without tax
Copyright 2004 South-Western
Figure 2 Tax Revenue

Price
Tax Revenue
T = the size of the tax
Q = the quantity of the good sold
Supply
Price buyers
pay
Size of tax (T)

Tax
revenue
(T Q)
T Q = the governments tax revenue

Price sellers
receive
Demand
Quantity
sold (Q)
0
Quantity
with tax
Quantity
without tax
Quantity
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Figure 3 How a Tax Effects Welfare

Price
Price
buyers = PB
pay
Changes in Welfare
Price
without tax = P1
Price
sellers = PS
receive
A deadweight loss is the fall in total surplus that

results from a market distortion, such as a tax.
Supply
D
F
Demand
Q2
Q1
Quantity
How a Tax Affects Welfare

The change in total welfare includes:
The change in consumer surplus,

The change in producer surplus, and
The change in tax revenue.
The losses to buyers and sellers exceed the revenue
raised by the government.
This fall in total surplus is called the deadweight
loss.
10/21/2015
Deadweight Losses and the Gains from

Trade
Taxes cause deadweight losses because they
prevent buyers and sellers from realizing some
of the gains from trade.
Figure 4 The Deadweight Loss

Price
Lost gains
from trade
PB
Supply
Size of tax
Price
without tax
PS
Cost to
sellers
Value to
buyers
0
Q2
Demand
Quantity
Q1
Reduction in quantity due to the tax
DETERMINANTS OF THE
DEADWEIGHT LOSS
What determines whether the deadweight loss
from a tax is large or small?
Figure 5 Tax Distortions and Elasticities

(a) Inelastic Supply
Price
Supply
The magnitude of the deadweight loss depends on

how much the quantity supplied and quantity
demanded respond to changes in the price.
That, in turn, depends on the price elasticities of
supply and demand.
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax
Demand
0
Quantity
10/21/2015
(b) Elastic Supply
(c) Inelastic Demand
Price
Price
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Supply
Supply
Size
of
tax
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Demand
Demand
Quantity
Quantity
DETERMINANTS OF THE
DEADWEIGHT LOSS
(d) Elastic Demand
The greater the elasticities of demand and

supply:
Price
Supply
the larger will be the decline in equilibrium

quantity and,
the greater the deadweight loss of a tax.
Size
of
tax
Demand
When demand is relatively
elastic, the deadweight
loss of a tax is large.
Quantity
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DEADWEIGHT LOSS AND TAX

REVENUE AS TAXES VARY
The Deadweight Loss Debate
Some economists argue that labor taxes are highly
distorting and believe that labor supply is more
elastic.
Some examples of workers who may respond more
to incentives:

With each increase in the tax rate, the
deadweight loss of the tax rises even more
rapidly than the size of the tax.
Workers who can adjust the number of hours they work

Families with second earners
Elderly who can choose when to retire
Workers in the underground economy (i.e., those
engaging in illegal activity)
Figure 6 Deadweight Loss and Tax Revenue from Three

Taxes of Different Sizes

(b) Medium Tax
(a) Small Tax

Price
Price
Deadweight
loss Supply
Deadweight
loss
PB
Supply
PB
Tax revenue
Tax revenue
PS
Q2
Demand
PS
Q1 Quantity
Demand
Q2
Q1 Quantity
10/21/2015

(c) Large Tax
Price
PB
Tax revenue
Deadweight
loss
Supply

For the small tax, tax revenue is small.
As the size of the tax rises, tax revenue grows.
But as the size of the tax continues to rise, tax
revenue falls because the higher tax reduces the
size of the market.
Demand
PS
0
Q2
Q1 Quantity
Figure 7 How Deadweight Loss and Tax Revenue Vary with

the Size of a Tax
Figure 7 How Deadweight Loss and Tax Revenue Vary with

the Size of a Tax
(a) Deadweight Loss
(b) Revenue (the Laffer curve)

Tax
Revenue
Deadweight
Loss
Tax Size
Tax Size
10/21/2015

CASE STUDY: The Laffer Curve and Supplyside Economics
As the size of a tax increases, its deadweight

loss quickly gets larger.
By contrast, tax revenue first rises with the size
of a tax, but then, as the tax gets larger, the
market shrinks so much that tax revenue starts
to fall.
The Laffer curve depicts the relationship

between tax rates and tax revenue.
Supply-side economics refers to the views of
Reagan and Laffer who proposed that a tax cut
would induce more people to work and thereby
have the potential to increase tax revenues.
Summary
Summary
A tax on a good reduces the welfare of buyers

and sellers of the good, and the reduction in
consumer and producer surplus usually exceeds
the revenues raised by the government.
The fall in total surplusthe sum of consumer
surplus, producer surplus, and tax revenue is
called the deadweight loss of the tax.
Taxes have a deadweight loss because they

cause buyers to consume less and sellers to
produce less.
This change in behavior shrinks the size of the
market below the level that maximizes total
surplus.
10/21/2015
Summary
As a tax grows larger, it distorts incentives
more, and its deadweight loss grows larger.
Tax revenue first rises with the size of a tax.
Eventually, however, a larger tax reduces tax
revenue because it reduces the size of the
market.

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10/21/2015

Application: The Costs of Taxation

Welfare economics is the study of how the

THE DEADWEIGHT LOSS OF

Copyright 2004 South-Western/Thomson Learning

THE DEADWEIGHT LOSS OF

Copyright 2004 South-Western/Thomson Learning

Figure 1 The Effects of a Tax

How a Tax Affects Market Participants

A tax places a wedge between the price buyers

Copyright 2004 South-Western/Thomson Learning

Copyright 2004 South-Western

Figure 2 Tax Revenue

How a Tax Affects Market Participants

Size of tax (T)

T Q = the governments tax revenue

Figure 3 How a Tax Effects Welfare

How a Tax Affects Market Participants

A deadweight loss is the fall in total surplus that

Copyright 2004 South-Western/Thomson Learning

Copyright 2004 South-Western

How a Tax Affects Welfare

How a Tax Affects Market Participants

The change in consumer surplus,

Copyright 2004 South-Western/Thomson Learning

Copyright 2004 South-Western/Thomson Learning

Deadweight Losses and the Gains from

Figure 4 The Deadweight Loss

Copyright 2004 South-Western/Thomson Learning

Copyright 2004 South-Western

Figure 5 Tax Distortions and Elasticities

The magnitude of the deadweight loss depends on

Figure 5 Tax Distortions and Elasticities

Figure 5 Tax Distortions and Elasticities

(b) Elastic Supply

(c) Inelastic Demand

Copyright 2004 South-Western

Figure 5 Tax Distortions and Elasticities

(d) Elastic Demand

The greater the elasticities of demand and

the larger will be the decline in equilibrium

Copyright 2004 South-Western/Thomson Learning

DEADWEIGHT LOSS AND TAX

DEADWEIGHT LOSS AND TAX

Workers who can adjust the number of hours they work

Figure 6 Deadweight Loss and Tax Revenue from Three

Copyright 2004 South-Western/Thomson Learning

Figure 6 Deadweight Loss and Tax Revenue from Three

(a) Small Tax

Copyright 2004 South-Western

Figure 6 Deadweight Loss and Tax Revenue from Three

DEADWEIGHT LOSS AND TAX

Copyright 2004 South-Western

Figure 7 How Deadweight Loss and Tax Revenue Vary with

Figure 7 How Deadweight Loss and Tax Revenue Vary with

(a) Deadweight Loss

(b) Revenue (the Laffer curve)

DEADWEIGHT LOSS AND TAX

CASE STUDY: The Laffer Curve and Supplyside Economics

As the size of a tax increases, its deadweight

The Laffer curve depicts the relationship

Copyright 2004 South-Western/Thomson Learning

Copyright 2004 South-Western/Thomson Learning