Cost and Inefficiency of
Taxes/Subsidies
Taxes and Deadweight Loss
• Outcome of Tax
– Buyers pay higher price
– Sellers get lower price
– “Tax Wedge”
– Lower quantity sold
• Burden of Tax
– Split between buyer and seller
– Depends on elasticities
Buyer
Post Tax
Price
Pre Tax
Price
Size of Tax
Seller
Post Tax
Price
Post Tax
Quantity
Pre Tax
Quantity
Winners and Losers
• Losers
– Buyers: Pay higher price so lower consumer
surplus
– Sellers: Get lower price so lower producer surplus
• Winners
– Gov’t (other tax payers): gain revenue from taxes
raised = [New Quantity x Tax]
Losers
Lost Consumer Surplus
Buyer
Post Tax
Price
Pre Tax
Price
Seller
Post Tax
Price
Lost Producer Surplus
Post Tax
Quantity
Pre Tax
Quantity
Winners
Taxes Raised: Q x T
Buyer
Post Tax
Price
Pre Tax
Price
Seller
Post Tax
Price
Post Tax
Quantity
Pre Tax
Quantity
• Welfare Before Tax
– Consumer Surplus
– Producer Surplus
– Tax Revenue = 0
• Welfare After Tax
– Smaller Consumer Surplus
– Smaller Producer Surplus
– Positive Tax Revenue
– Smaller overall Welfare
Buyer
Post Tax
Price
Deadweight Loss: CS and PS
lost but not gained back by tax
revenue
Pre Tax
Price
Seller
Post Tax
Price
Post Tax
Quantity
Pre Tax
Quantity
A
W/O Tax With Tax Change
Buyer
Post Tax
Price
Pre Tax
Price
Seller
Post Tax
Price
B
C
E
D
F
Post Tax
Quantity
Pre Tax
Quantity
C.S.
A+B+C
A
-(B+C)
P.S.
D+E+F
F
-(D+E)
Tax
0
B+D
+(B+D)
Overall
A+B+C+
D+E+F
A+B+D+F -(C+E)
• Consumer surplus goes down
– Some gained by tax revenue
– Some lost
• Producer surplus goes down
– Some gained by tax revenue
– Some lost
• Overall surplus (welfare) goes down because
of lower quantity in market
– Market is smaller, so some product/service are not
made even though market value is higher than
cost, ie Inefficient
The fact that Gov’t gets some revenue that
once was consumer/producer surplus is not
where loss of welfare comes from
Buyer
Post Tax
Price
Value to buyers (height of
demand curve) higher than cost
to producers (height of supply
curve), so should produce at
these levels, but not because of
tax – this is why welfare is lost,
or surplus goes down.
Pre Tax
Price
Seller
Post Tax
Price
Post Tax
Quantity
Pre Tax
Quantity
Size of tax distortion/DWL
• Greater the elasticity of supply/demand the
greater the shrinkage of the market and
greater deadweight loss
• B/C markets are reacting more (elastic) to the
change in price due to the tax
• So market shrinks more and more welfare loss
because more potential trades that would
have led to gains are loss
Inelastic Markets – Low
Distortion and DWL
Elastic Markets – High
Distortion and DWL
DWL
DWL
Tax
Wedge
Q2 Q1
Tax
Wedge
Q2
Q1
Tax Revenue and Tax Size
• At first as you increase the size of a tax you
increase Revenue (Q x T)
• But at some point increasing size of tax
decreases revenue because the effect shrinks
the market so much there’s not much to tax
Low Tax – Low Revenue
Tax
Revenue
Med Tax – High Revenue
Tax
Revenue
High Tax – Low Revenue
Tax
Revenue
Laffer Curve
• Idea is based on previous thought
• Says that by decreasing tax (normally income
tax) could increase government revenue
• Popular Idea in the 80’s that still persists but
with less support – Why?
– Supply of labor fairly inelastic
– Actual income tax rate is not that high
• No big black market
Laffer Curve
Tax Revenue
But at what rate is the peak?
?
Size of Tax
Example
• Say $10 trillion economy with tax rate 30%
– Revenue is $3 trillion
• Then lower rate to 25% and get an extra $1
trillion in activity (big increase in activity)
– New revenue is $2.75 trillion
– In this case would need a 20% increase in activity
to break even, not very likely
• Though to be fair it is still debated, perhaps
Federal Income Tax Rate Ranges
Income Range
Marginal Tax Rate
$0 - $8,375
10%
$8,375 - $34,000
15%
$34,000 - $82,400
25%
$82,400 - $171,850
28%
$171,850 - $373,650
33%
$373,650 and up
35%
Iowa State Income Tax rate ranges from 0.36% - 8.98%
Inefficiency due to Subsidy
• Subsidy Increases the market size beyond the
market equilibrium
• This means the supply curve is above the
demand curve at the new quantity
• This means those last products produced cost
more to produce than they are actually valued
in the market
• This is inefficient
New Producer Surplus
Nobody Gains/Values
New Seller
Price
Subsidy Wedge
Initial Price
Government Pays for all 3
regions but the one region is
lost, ie inefficient
New Buyer
Price
New Consumer Surplus