Lesson Overview
Chapter 7 Taxes
Taxes and their Effects
Tax Incidence
Tax Revenue
Tax Rates and Revenue
The Deadweight Loss of a Tax
Deadweight Loss and Elasticities
The Tax System
Controversy: Welfare
Summary
Review Questions
BA 210 Lesson I.8 Taxes
1
Taxes and their Effects
Excise taxes
• An excise tax is a tax on sales of a good.
• Excise taxes:
 raise the price paid by buyers, called the buyers’ price
 reduce the price received by sellers, called the sellers’ price
BA 210 Lesson I.8 Taxes
2
Taxes and their Effects
The Supply and Demand for Hotel Rooms in Los Angeles
Price of hotel
room
$140
120
S
100
E
Equilibrium
price
80
B
60
D
40
20
0
5,000
10,000
Equilibrium
quantity
BA 210 Lesson I.8 Taxes
15,000
Quantity of hotel
rooms
3
Taxes and their Effects
An Excise Tax on Hotel Rooms can be analyzed by the Buyers’
price …
Buyers’ $140
Price of
hotel room 120
S
2
Supply curve shifts
upward by the amount
of the tax
A
S
1
100
Excise tax = $40
per room
E
80
60
D
B
40
20
0
5,000
10,000
15,000
Quantity of
hotel rooms
BA 210 Lesson I.8 Taxes
4
Taxes and their Effects
… or can be analyzed by the Sellers’ price
$140
Sellers’
Price of
hotel room
Demand curve shifts
downward by the
amount of the tax
120
A
S
100
Excise tax = $40
per room
E
80
60
D
1
B
40
20
0
D
2
5,000
10,000
15,000
Quantity of
hotel rooms
BA 210 Lesson I.8 Taxes
5
Tax Incidence
Tax Incidence
• The incidence of a tax measures who really bears the tax
burden.
• Who really bears the tax burden (in the form of higher prices to
consumers and lower prices to sellers) does not depend on who
officially pays the tax. For example, the hotel or the hotel guest.
• Depending on the shapes of supply and demand curves, the
incidence of an excise tax may be divided differently.
• The wedge between the demand price and supply price
becomes the government’s tax revenue.
BA 210 Lesson I.8 Taxes
6
Tax Incidence
An Excise Tax Paid Mainly By Consumers
Price of gasoline (per
gallon)
$2.95
Excise tax =
$1 per
gallon
Tax burden falls
mainly on
consumers
When the price
elasticity of demand
is much lower than
the price elasticity of
supply is high, the
burden of an excise
tax falls mainly on
consumers.
S
2.00
1.95
D
0
Quantity of gasoline (gallons)
BA 210 Lesson I.8 Taxes
7
Tax Incidence
An Excise Tax Paid Mainly By Producers
S
Price of parking
space
$6.50
6.00
Excise tax = $5
per parking space
Tax burden falls
mainly on
producers
1.50
0
When the
price elasticity
of demand is
high and the
price elasticity
D
of supply is
low, the
burden of an
excise tax
falls mainly
on producers.
Quantity of parking spaces
BA 210 Lesson I.8 Taxes
8
Tax Incidence
Tax Incidence Summary
• When the price elasticity of demand is higher than the price
elasticity of supply, an excise tax falls mainly on producers.
That makes sense because consumers have more substitutes in
demand.
• When the price elasticity of supply is higher than the price
elasticity of demand, an excise tax falls mainly on consumers.
That makes sense because producers have more substitutes in
supply.
• So elasticity determines the incidence of an excise tax.
BA 210 Lesson I.8 Taxes
9
Tax Revenue
Price of hotel
room
$140
120
The area of the shaded rectangle is:
Area = Height × Width
= $40 per room × 5,000 rooms = $200,000
The tax revenue collected is:
Tax revenue = $40 per room × 5,000 rooms
= $200,000
A
S
100
Excise tax = $40
per room
80
E
Area = tax
revenue
60
D
B
40
20
0
6
5,000
10,000
15,000
Quantity of hotel rooms
BA 210 Lesson I.8 Taxes
10
Tax Revenue
Tax revenue summary
• The revenue collected by an excise tax is equal to the area of
the rectangle whose height is the tax wedge between the
supply and demand curves and whose width is the quantity
transacted under the tax.
BA 210 Lesson I.8 Taxes
11
Tax Rates and Revenue
Tax Rates and Revenue
• A tax rate is the amount of tax people are required to pay per
unit of whatever is being taxed.
• In general, doubling the excise tax rate on a good or service
won’t double the amount of revenue collected, because the tax
increase will reduce the quantity of the good or service
transacted.
• In some cases, raising the tax rate may actually reduce the
amount of revenue the government collects.
BA 210 Lesson I.8 Taxes
12
Tax Rates and Revenue
Price of
hotel
room
(a) An excise tax of $20.
Revenue = $20 x 7,500 = $150,000
Price of
hotel
room
$140
$140
120
120
110
90
80
70
E
Area = tax
revenue
D
Excise
tax =
$60 per
room
80
Area = tax revenue
S
Excise
tax =
$20 per
room
(b) An excise tax of $60.
Revenue = $60 x 2,500 = $150,000
S
E
D
50
40
40
20
20
0
6,000
7,500 10,000
15,000
0
Quantity of hotel rooms
BA 210 Lesson I.8 Taxes
2,500 5,000
10,000
15,000
Quantity of hotel rooms
13
The Deadweight Loss of a Tax
A Tax Reduces Consumer and Producer Surplus
• A fall in the price of a good causes a gain in consumer surplus.
Similarly, a price increase causes a loss in consumer surplus.
So, in the case of an excise tax, the rise in the price paid by
consumers causes a loss in consumer surplus.
• Likewise, the fall in the price received by producers causes a
loss in producer surplus.
• Therefore, an excise tax reduces both consumer surplus and
producer surplus.
BA 210 Lesson I.8 Taxes
14
The Deadweight Loss of a Tax
A Tax Reduces Consumer and Producer Surplus
Fall in consumer surplus
due to tax
Pri c e
P
C
A
Excise tax = T
P
B
E
E
F
C
P
S
P
Fall in producer surplus
due to tax
Q
T
Q
E
BA 210 Lesson I.8 Taxes
D
Quantity
15
The Deadweight Loss of a Tax
The Deadweight Loss of a Tax
• Although consumers and producers are hurt by the tax, the
government gains revenue. The revenue the government
collects is equal to the tax per unit sold, T, multiplied by the
quantity sold, QT.
• But a portion of the loss to producers and consumers from the
tax is not offset by a gain to the government.
• The deadweight loss caused by the tax represents the total
surplus lost to society because of the tax — that is, the amount
of surplus that would have been generated by transactions that
now do not take place because of the tax.
• The deadweight loss is the change in total surplus if the tax
revenue were simply given back to members of society --- for
example, as a type of welfare payment.
BA 210 Lesson I.8 Taxes
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The Deadweight Loss of a Tax
Price
S
Deadweight loss
P
Excise tax = T
P
P
C
E
E
P
D
Q
T
Q
E
BA 210 Lesson I.8 Taxes
Quantity
17
The Deadweight Loss of a Tax
• The administrative costs of a tax are the resources used by
government to collect the tax, and by taxpayers to pay it, over
and above the amount of the tax, as well as to evade it.
• The total inefficiency caused by a tax is the sum of its
deadweight loss and its administrative costs. The general rule
for economic policy is that, other things equal, a tax system
should be designed to minimize the total inefficiency it
imposes on society.
BA 210 Lesson I.8 Taxes
18
Deadweight Loss and Elasticities
Deadweight Loss and Elasticities
(a) Elastic Demand
(b) Inelastic Demand
S
S
Price
Price
Deadweight loss is
larger when
demand is elastic
P
C
Excise
tax = T
P
C
P
E
E
Excise
tax = T
P
E
P
P
E
D
Deadweight loss is
smaller when
demand is
inelastic
P
P
D
Q
T
Q
E
Quantity
BA 210 Lesson I.8 Taxes
Q Q
T E
Quantity
19
Deadweight Loss and Elasticities
Deadweight Loss and Elasticities
(c) Elastic Supply
Price
(d) Inelastic Supply
S
Price
Deadweight loss
is larger when
supply is elastic
P
C
S
P
C
Excise
tax = T
P
E
P
P
E
Excise
tax = T
P
E
E
Deadweight
loss is smaller
when supply is
inelastic
P
P
D
Q
T
Q
E
D
Quantity
BA 210 Lesson I.8 Taxes
Q Q
T E
Quantity
20
Deadweight Loss and Elasticities
Deadweight Loss and Elasticities
• To minimize the efficiency costs of taxation, one should
choose to tax only those goods for which demand or supply, or
both, is relatively inelastic.
• For such goods, a tax has little effect on behavior because
behavior is relatively unresponsive to changes in the price.
BA 210 Lesson I.8 Taxes
21
Deadweight Loss and Elasticities
Deadweight Loss and Elasticities
• In the extreme case in which demand were perfectly inelastic
(a vertical demand curve), the quantity demanded is
unchanged by the imposition of the tax. As a result, the tax
imposes no deadweight loss.
• Similarly, if supply were perfectly inelastic (a vertical supply
curve), the quantity supplied is unchanged by the tax and there
is also no deadweight loss.
BA 210 Lesson I.8 Taxes
22
Deadweight Loss and Elasticities
Deadweight Loss and Elasticities
• If the goal in choosing whom to tax is to minimize deadweight
loss, then taxes should be imposed on goods that have the most
inelastic response—that is, goods and services for which
consumers or producers will change their behavior the least in
response to the tax.
BA 210 Lesson I.8 Taxes
23
The Tax System
The Tax System
• The tax base is the measure or value, such as income or
property value, that determines how much tax an individual or
firm pays.
• The tax structure specifies how the tax depends on the tax
base.
• Once the tax base has been defined, the next question is how
the tax depends on the base. The simplest tax structure is a
proportional tax, also sometimes called a flat tax, which is the
same percentage of the base regardless of the taxpayer’s
income or wealth.
BA 210 Lesson I.8 Taxes
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The Tax System
BA 210 Lesson I.8 Taxes
25
The Tax System
Some important taxes and their tax bases are as follows:
• Income tax: a tax that depends on the income of an individual
or a family from wages and investments
• Payroll tax: a tax that depends on the earnings an employer
pays to an employee
• Sales tax: a tax that depends on the value of goods sold (also
known as an excise tax)
• Profits tax: a tax that depends on a firm’s profits
• Property tax: a tax that depends on the value of property, such
as the value of a home
• Wealth tax: a tax that depends on an individual’s wealth
BA 210 Lesson I.8 Taxes
26
The Tax System
BA 210 Lesson I.8 Taxes
27
The Tax System
• Once the tax base has been defined, the next question is how
the tax depends on the base. The simplest tax structure is a
proportional tax, also sometimes called a flat tax, which is the
same percentage of the base regardless of the taxpayer’s
income or wealth.
• State and, especially, local governments generally do not make
much effort to increase the tax on high income or wealth . This
is largely because they are subject to tax competition: a state or
local government that imposes high taxes on people with high
incomes faces the prospect that those people may move to
other locations where taxes are lower.
BA 210 Lesson I.8 Taxes
28
Controversy: Welfare
Controversy: Welfare
BA 210 Lesson I.8 Taxes
29
Controversy: Welfare
Welfare consists of actions or procedures — especially on the
part of governments and institutions — striving to promote the
basic well-being of individuals in need. These efforts usually
strive to improve the financial situation of people in need but may
also strive to improve their employment chances and many other
aspects of their lives including sometimes their mental health. In
many countries, most such aid is provided by family members,
relatives, and the local community.
Welfare in most countries is provided to those who are
unemployed, those with illness or disability, those of old age,
those with dependent children.
BA 210 Lesson I.8 Taxes
30
Controversy: Welfare
Microeconomics lessons on Revealed Preference and on Taxes
reveal that the controversy over the level of welfare and who
deserves welfare is caused by the controversy over the rationality
of those in need.
If everyone were rational, then Revealed Preference shows
someone that is unemployed has high consumption of leisure
time and, so, may be happier than someone that is employed.
Likewise, Revealed Preference shows someone with dependent
children has high consumption of children as a commodity and,
so, may be happier than someone without children. And
Revealed Preference shows people may be happier if they
received tax break when young rather than welfare in old age.
BA 210 Lesson I.8 Taxes
31
Controversy: Welfare
Finally, even if welfare cash is not a subsidy for the consumption
of children and is not delayed until old age, welfare is still
controversial because of the deadweight loss of the tax that is
needed to pay for welfare.
BA 210 Lesson I.8 Taxes
32
Controversy: Welfare
Question: Consider the market for labor in the US, illustrated in
the accompanying table.
Wage
Quantity of
Quantity of
Labor
Labor
Suppose the US decides to
Demanded
Supplied
impose a $4 tax on wages and
$9
0
7
to give the revenue back as
$8
0
6
welfare.
1
5
a. What is the quantity of labor $7
$6
2
4
bought and sold after the
$5
3
3
imposition of the tax? What is
4
2
wage paid by employers? What $4
5
1
is the wage received by workers? $3
b. Calculate the consumer surplus and the producer surplus after
the imposition of the tax. By how much has the imposition of the
tax reduced total surplus?
c. How much revenue does the US earn from this tax?
BA 210 Lesson I.8 Taxes
33
Controversy: Welfare
Answer: a. The tax drives a wedge between the price paid by
consumers and the wage received Wage
Quantity of
Quantity of
Labor
Labor
by workers. Consumers now pay
Demanded
Supplied
$7, and workers receive $3. So
$9
0
7
after the imposition of the tax,
0
6
the quantity bought and sold will $8
$7
1
5
be 1 unit of labor.
2
4
b. Consumer surplus before the $6
$5
3
3
tax was $3 (at wage = $5) and
$4
4
2
is now $0 (at wage = $7).
5
1
Producer (worker) surplus before $3
the tax was $3 (at wage = $5) and is now $0 (at wage = $3). So,
the imposition of the tax reduced total surplus by $6.
c. The US earns a tax of $4 per unit sold, which is a total tax
revenue of $4.
BA 210 Lesson I.8 Taxes
34
Controversy: Welfare
Comment: The total tax revenue of $4 allows $4 of welfare to be
dispersed. But consumers and
Wage
Quantity of
Quantity of
Labor
Labor
producers of labor are hurt $6,
Demanded
Supplied
which is more than the welfare
$9
0
7
recipients are helped. In this
$8
0
6
sense, welfare decreased total
$7
1
5
prosperity in the US and, so,
2
4
is objectionable to a Utilitarian, $6
$5
3
3
who measures society’s
$4
4
2
well-being by total happiness.
$3
BA 210 Lesson I.8 Taxes
5
1
35
Summary
Summary
1. Excise taxes — taxes on the purchase or sale of a good—
raise the price paid by consumers and reduce the price
received by producers, driving a wedge between the two.The
incidence of the tax—how the burden of the tax is divided
between consumers and producers—does not depend on who
officially pays the tax.
2. The incidence of an excise tax depends on the price
elasticities of supply and demand. If the price elasticity of
demand is higher than the price elasticity of supply, the tax
falls mainly on producers; if the price elasticity of supply is
higher than the price elasticity of demand, the tax falls
mainly on consumers.
BA 210 Lesson I.8 Taxes
36
Summary
3.
4.
The tax revenue generated by a tax depends on the tax rate
and on the number of units transacted with the tax. Excise
taxes cause inefficiency in the form of deadweight loss
because they discourage some mutually beneficial
transactions. Taxes also impose administrative costs —
resources used to collect the tax.
An excise tax generates revenue for the government, but
lowers total surplus. The loss in total surplus exceeds the tax
revenue, resulting in a deadweight loss to society. This
deadweight loss is represented by a triangle, the area of
which equals the value of the transactions discouraged by the
tax. The greater the elasticity of demand or supply, or both,
the larger the deadweight loss from a tax. If either demand or
supply is perfectly inelastic, there is no deadweight loss from
a tax.
BA 210 Lesson I.8 Taxes
37
Summary
5.
6.
An efficient tax minimizes both the sum of the deadweight
loss due to distorted incentives and the administrative costs
of the tax. However, tax fairness, or tax equity, is also a goal
of tax policy.
There are two major principles of tax fairness, the benefits
principle and the ability-to-pay principle. The most efficient
tax, a lump-sum tax, does not distort incentives but performs
badly in terms of fairness. The fairest taxes in terms of the
ability-to-pay principle, however, distort incentives the most
and perform badly on efficiency grounds. So in a welldesigned tax system, there is a trade-off between equity and
efficiency.
BA 210 Lesson I.8 Taxes
38
Summary
7.
8.
Every tax consists of a tax base, which defines what is taxed,
and a tax structure, which specifies how the tax depends on
the tax base. Different tax bases give rise to different taxes—
the income tax, payroll tax , sales tax, profits tax , property
tax, and wealth tax.
A tax is progressive if higher-income people pay a higher
percentage of their income in taxes than lower-income
people and regressive if they pay a lower percentage.
Progressive taxes are often justified by the ability-to-pay
principle. However, a highly progressive tax system
significantly distorts incentives because it leads to a high
marginal tax rate, the percentage of an increase in income
that is taxed away, on high earners. The U.S. tax system is
progressive overall, although it contains a mixture of
progressive and regressive taxes.
BA 210 Lesson I.8 Taxes
39
Review Questions
Review Questions
 You should try to answer some of the following questions
before the next class.
 You will not turn in your answers, but students may request
to discuss their answers to begin the next class.
 Your upcoming Exam 1 and cumulative Final Exam will
contain some similar questions, so you should eventually
consider every review question before taking your exams.
BA 210 Lesson I.8 Taxes
40
Review Questions
Follow the link
http://faculty.pepperdine.edu/jburke2/ba210/PowerP1/Set7Answers.pdf
for review questions for Lesson I.8 that practices these skills:
 Compute the effects of an excise tax on price, quantity, and tax
revenue.
 Show how the tax burden is divided between consumers and
producers according to demand and supply elasticity.
 Compute the effects of an excise tax on consumer and producer
surplus.
BA 210 Lesson I.8 Taxes
41
BA 210
Introduction to Microeconomics
End of Lesson I.8
BA 210 Lesson I.8 Taxes
42