Chapter 8
Application: The Costs of Taxation
In this chapter, look for the answers to these questions:
• How does a tax affect consumer surplus, producer surplus and
total surplus?
• What is the deadweight loss of a tax?
• What factors determine the size of this deadweight loss?
• How does tax revenue depend on the size of the tax?
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How a Tax Affects Market Participants
 Tax on a good levied on buyers
 Demand curve shifts left (downward)
 By the size of tax
 Tax on a good levied on sellers
 Supply curve shifts left (upward)
 By the size of tax
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How a Tax Affects Market Participants
 Tax on a good levied on buyers or on sellers
 Same outcome: a price wedge
 Price paid by buyers rises
 Price received by sellers falls
 Lower quantity sold
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How a Tax Affects Market Participants
 Tax burden
 Distributed between producers and consumers
 Determined by elasticities of supply and demand
 Market for the good
 Smaller
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How a Tax Affects Market Participants
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How a Tax Affects Market Participants
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How a Tax Affects Welfare
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Deadweight Loss of Taxation
 Losses of surplus to buyers and sellers, from
a tax
 Exceed the revenue raised by the government
 Deadweight loss
 Fall in total surplus that results from a market
distortion, such as a tax
 Taxes distort incentives
 Markets allocate resources inefficiently
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Active Learning 1
Analysis of tax
The market for
airplane tickets
P
$ 400
A. Compute CS, PS
and total surplus
without a tax.
B. If $100 tax per
ticket, compute
CS, PS, tax
revenue, total
surplus and
deadweight loss.
350
300
S
250
200
150
D
100
50
Q
0
0
25
50
75 100 125
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Active Learning 1
Answers to A
CS
= ½ x $200 x 100
= $10,000
PS
= ½ x $200 x 100
= $10,000
Total surplus
= $10,000 + $10,000
= $20,000
The market for
airplane tickets
P
$ 400
350
300
S
250
P = 200
150
D
100
50
Q
0
0
25
50
75 100 125
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Active Learning 1
Answers to B
CS
= ½ x $150 x 75
= $5,625
P
$ 400
350
300
PS = $5,625
PB = 250
Tax revenue
= $100 x 75
= $7,500
200
Total surplus
= $18,750
DWL = $1,250
A $100 tax on
airplane tickets
S
PS = 150
D
100
50
Q
0
0
25
50
75 100 125
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Deadweight Loss of Taxation
 Deadweight losses and gains from trade
 Taxes cause deadweight losses
 Prevent buyers and sellers from realizing some of the
gains from trade
 The gains from trade
 Difference between buyers’ value and sellers’ cost
are less than the tax
 Once the tax is imposed some trades are not made:
deadweight loss
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Figure 4 The Source of a Deadweight Loss
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Exercise: Tax on Potato Sellers
Compute the following:
• P and Q before tax
• CS, PS, TS before tax
• P and Q after tax
• Amount of tax per unit
• Tax incidence (burden on buyers
and sellers)
• CS, PS, tax revenue, TS after tax
• DWL
The Determinants of the Deadweight Loss
• The size of the deadweight loss depends on the price elasticities of
supply and demand.
• Recall: The price elasticity of demand (or supply) measures how
much QD (or QS) changes when P changes.
• Price elasticities of supply and demand
• More elastic supply curve
• Larger deadweight loss
• More elastic demand curve
• Larger deadweight loss
• The greater the elasticities of supply and demand
• The greater the deadweight loss of a tax
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Figure 5 Tax Distortions and Elasticities (a, b)
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Figure 5 Tax Distortions and Elasticities (c, d)
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Active Learning 2
Elasticity and the DWL of a tax
Would the DWL of a tax be larger if the
tax were on:
A. breakfast cereal or sunscreen?
B. hotel rooms in the short-run or
hotel rooms in the long-run?
C. groceries or meals at fancy restaurants?
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Active Learning 2
Answers
A. Breakfast cereal or sunscreen.
Breakfast cereal has more close substitutes than sunscreen,
so demand for breakfast cereal
is more price-elastic than demand for sunscreen.
So, a tax on breakfast cereal would cause a larger DWL than
a tax on sunscreen.
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Active Learning 2
Answers
B. Hotel rooms in the short-run or long-run.
The price elasticities of demand and supply
for hotel rooms are larger in the long run than
in the short run.
So, a tax on hotel rooms would cause a larger DWL in the long
run than in the short run.
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Active Learning 2
Answers
C. Groceries or meals at fancy restaurants.
Groceries are more of a necessity and therefore less priceelastic than meals at fancy restaurants.
So, a tax on restaurant meals would cause a larger DWL than
a tax on groceries.
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The Deadweight Loss Debate
 How big should the government be?
 The larger the deadweight loss of taxation
 The larger the cost of any government program
 If taxes impose large deadweight losses
 These losses are a strong argument for a leaner
government that does less and taxes less
 If taxes impose small deadweight losses
 Government programs are less costly
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The Deadweight Loss Debate
 How big are the deadweight losses of taxation?
 Economists disagree
 Tax on labor (the labor tax)
 Social Security tax, Medicare tax, much of federal
income tax
 Places a wedge between the wage that firms pay
and the wage that workers receive
 Marginal tax rate on labor income is 40% (tax rate
on the last dollar of earnings)
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The Deadweight Loss Debate
 40% labor tax: Small or large
deadweight loss?
 Some believe labor supply
is fairly inelastic
 Almost vertical
 Most people would work full-time
regardless of wage
“What’s your
position on the
elasticity of labor
supply?”
 Tax on labor: small deadweight
loss
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The Deadweight Loss Debate
 Others: labor supply is more elastic
 Tax on labor: greater deadweight loss
 Many workers can adjust the number of hours they
work (overtime)
 Some families have second earners; some
discretion over whether to do unpaid work at home
or paid work in the marketplace
 Many of the elderly can choose when to retire
 Some people consider engaging in illegal economic
activity (underground economy)
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Deadweight Loss & Tax Revenue
 As the tax increases
 Deadweight loss increases
 Even more rapidly than the size of the tax
 Tax revenue
 Increases initially
 Then decreases
 The higher tax: drastically reduces the size of the
market
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DWL and the Size of the Tax
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DWL and the Size of the Tax
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The Laffer Curve and Supply-Side Economics
 Economists
 Continue to debate Arthur Laffer’s argument
 No consensus about the size of the relevant
elasticities
 General lesson:
 Change in tax revenue from a tax change
depends on how the tax change affects people’s
behavior
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Summary
• A tax on a good reduces the welfare of buyers and sellers. This
welfare loss usually exceeds the revenue the tax raises for the
government.
• The fall in total surplus (consumer surplus, producer surplus and
tax revenue) is called the deadweight loss (DWL) of the tax.
• A tax has a DWL because it causes consumers to buy less and
producers to sell less, thus shrinking the market below the level
that maximizes total surplus.
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Summary
• The price elasticities of demand and supply measure how much
buyers and sellers respond to price changes. Therefore, higher
elasticities imply higher DWLs.
• An increase in the size of a tax causes the DWL to rise even
more.
• An increase in the size of a tax causes revenue to rise at first,
but eventually revenue falls because the tax reduces the size of
the market.
For use with Principle of Economics Arab World Edition, 4e by N. Gregory Mankiw and Mohamed H. Rashwan (9781473774926) © 2022 Cengage Learning
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