8
Application: The Costs of
Taxation
The Effects of Taxation
• We saw in Chapter 6 how taxes
– reduce the equilibrium quantity,
– increase the price paid by buyers, and
– decrease the price received by sellers.
• We also saw that
– It does not matter whether a tax is placed on the
buyers or the sellers;
• the outcome is the same in either case
• But how do taxes affect the economic wellbeing of market participants?
2
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
Welfare Economics
• Welfare economics is the study of how the
allocation of resources affects economic wellbeing.
• We saw in Chapter 7 that
– Buyers benefit from buying (consumer surplus),
and
– Sellers benefit from selling (producer surplus)
– The equilibrium outcome in a perfectly competitive
market maximizes the total surplus of society.
3
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
Applying welfare economics to study
the effects of taxation
• In this chapter we will combine what we
learned in Chapters 6 and 7 to compare the
costs and the benefits of a tax
4
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
Figure1 The Effects of a Tax
Buyers’ Price
Sellers’ price
Supply
Price buyers pay
Size of tax
Price
without tax
Price sellers
receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
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 sold
falls below the level that would be sold without
a tax.
– See Chapter 6 for details
• This fall in output is the cost of the tax
6
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
How a Tax Affects Market Participants
• Governments earn revenue from taxes
• This revenue is the benefit of the tax
• Tax Revenue
– T = the size of the tax
– Q = the quantity of the good sold
T  Q = the government’s tax revenue
7
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
Figure 2 Tax Revenue
Price
Supply
Price buyers
pay
Size of tax (T)
Tax
revenue
(T × Q)
Price sellers
receive
Demand
Quantity
sold (Q)
0
Quantity
with tax
Quantity
without tax
Quantity
Figure 3 How a Tax Affects Welfare
Price
Price
buyers = PB
pay
Supply
A
B
C
Price
without tax = P1
Price
sellers = PS
receive
E
D
F
Demand
0
Q2
Q1
Quantity
Deadweight Losses and the Gains from
Trade
• The cost of a tax exceeds the benefit of a tax
• The decrease in total surplus that is caused by
a tax is the deadweight loss of the tax
• Taxes cause deadweight losses because they
prevent buyers and sellers from realizing some
of the gains from trade.
13
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
Price
Figure 4 The Deadweight Loss
Lost gains
from trade
PB
Supply
Size of tax
Price
without tax
PS
Cost to
sellers
Value to
buyers
0
Q2
Demand
Q1
Reduction in quantity due to the tax
Quantity
DETERMINANTS OF THE DEADWEIGHT
LOSS
• What determines whether the deadweight loss
from a tax is large or small?
– The size of the deadweight loss depends on how
much the quantity supplied and quantity
demanded respond to changes in the price.
– In other words, the size of a tax’s deadweight loss
depends on the price elasticities of supply and
demand.
15
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
Figure 5 Tax Distortions and Elasticities
(a) Inelastic Supply
Price
Supply
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax
Demand
0
Quantity
Figure 5 Tax Distortions and Elasticities
(b) Elastic Supply
Price
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Size
of
tax
Supply
Demand
0
Quantity
Figure 5 Tax Distortions and Elasticities
(c) Inelastic Demand
Price
Supply
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Demand
0
Quantity
Figure 5 Tax Distortions and Elasticities
(d) Elastic Demand
Price
Supply
Size
of
tax
Demand
When demand is relatively
elastic, the deadweight
loss of a tax is large.
0
Quantity
DETERMINANTS OF THE DEADWEIGHT
LOSS
• The greater the elasticities of demand and
supply:
– the larger the decline in equilibrium quantity and,
– the greater the deadweight loss of a tax.
20
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
The Deadweight Loss Debate
• Some economists argue that taxes on labor income
are highly distorting—that is, taxes on labor income
have high deadweight losses—because they believe
that labor supply is elastic.
– Here are some examples of workers who may respond
more to incentives:
•
•
•
•
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)
21
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
DEADWEIGHT LOSS AND TAX REVENUE AS
TAXES VARY
• With each increase in the tax rate, the
deadweight loss of the tax rises even more
rapidly than the size of the tax.
22
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
Figure 6 Deadweight Loss and Tax Revenue from
Three Taxes of Different Sizes
(a) Small Tax
Price
Deadweight
loss Supply
PB
Tax revenue
PS
Demand
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
Figure 6 Deadweight Loss and Tax Revenue from
Three Taxes of Different Sizes
(b) Medium Tax
Price
Deadweight
loss
PB
Supply
Tax revenue
PS
0
Demand
Q2
Q1 Quantity
When the tax
rate doubles,
the deadweight
loss quadruples
Figure 6 Deadweight Loss and Tax Revenue from
Three Taxes of Different Sizes
(c) Large Tax
Price
PB
Tax revenue
Deadweight
loss
Supply
Demand
PS
0
Q2
Q1 Quantity
Figure 6 How Deadweight Loss and Tax Revenue Vary with the
Size of a Tax
(d) deadweight loss continually increases
Deadweight
Loss
0
Tax Size
DEADWEIGHT LOSS AND TAX
REVENUE AS TAXES VARY
• 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
quantity bought and sold shrinks so much that
tax revenues start to fall.
27
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
DEADWEIGHT LOSS AND TAX REVENUE AS
TAXES VARY
• Tax revenue = tax rate × quantity bought and
sold
– TR = T × Q
•
•
•
•
•
T↑ causes Q↓
Therefore, the effect of T↑ on TR is ambiguous
T↑ causes TR↑ when the tax rate (T) is low
T↑ causes TR↓ when the tax rate (T) is high
This gives us the Laffer Curve
28
Figure 6 How Deadweight Loss and Tax Revenue Vary with the
Size of a Tax
(e) Tax revenue first increases, then decreases (the Laffer curve)
Tax
Revenue
Note that it
makes no sense
at all to make
the tax size
bigger than T1.
0
T1
Tax Size
CASE STUDY: The Laffer Curve and SupplySide Economics
• The Laffer curve depicts the relationship between
tax rates and tax revenue.
• Supply-side economics refers to the view that a tax
cut
– would induce more people to work, and thereby
– have the potential to increase tax revenues.
• Large tax cuts were adopted during the Reagan
administration
• The results do not settle the debate on the validity
of supply-side economics
30
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
CASE STUDY: The Laffer Curve and
Supply-Side Economics
• Between the early 1970s and mid 1990s, the
French tax rate rose to 59 percent from 49
percent, while the U.S. tax rate held at 40
percent
• The average French person of working age logged
24.4 hours a week in the early 1970s, one hour
more than an American. By the mid 1990s, the
French workweek had shrunk to 17.5 hours,
while the U.S. workweek had grown to 25.9
hours
– Data from research by Edward Prescott
31
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
CASE STUDY: The Laffer Curve and
Supply-side Economics
Country
Tax Rate
Workweek
Italy
64%
16.5 hours
France
59
17.5
Germany
59
19.3
Canada
52
22.8
UK
44
22.9
USA
40
25.9
Japan
37
27.0
Data from research by
Edward Prescott
32
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
The Price of a Civilized Society
• This chapter has focused on the negative
effects of taxes on buyers and sellers in a
market
• However, without taxes we would not have a
functioning government
• As Oliver Wendell Holmes, Jr., Supreme Court
Justice, once said, “Taxes are the price we pay
for a civilized society."
33
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
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 surplus—the sum of consumer
surplus, producer surplus, and tax revenue —
is called the deadweight loss of the tax.
34
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
Summary
• 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.
35
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
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.
36
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION