Deadweight Loss of Taxation

Chapter 8
The Costs of Taxation
Copyright (c) 1999 Harcourt Brace & Company, Canada, Ltd. All rights reserved.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Market Efficiency: Three observations
Free
markets allocate the supply of
goods to the buyers who value them
most highly.
Free markets allocate the demand for
goods to the sellers who can produce
them at least cost.
Free markets produce the quantity of
goods that maximizes the sum of
consumer and producer surplus.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
The Costs of Taxation
A
tax places a wedge
between the price
buyers pay and the
price sellers receive.
Tax!
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
The Costs of Taxation
A
tax places a wedge
between the price
buyers pay and the
price sellers receive.
A tax results in a
Deadweight Loss to
society and the
economy
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
Tax! Loss!
First Canadian Edition
Deadweight Loss of Taxation: Graphical
Supply
$.50
Demand
1000
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Deadweight Loss of Taxation: Graphical
Supply
$.60
$.20 tax
imposed
$.50
$.40
Demand
800 1000
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Deadweight Loss of Taxation: Example
The
twenty cent tax results in new
prices to consumers and producers:
– Consumers pay $0.60
– Sellers receive $0.40
The
Tax Revenue from the imposed tax
is = $160
i.e. [($0.60-$0.40) x 800]
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Deadweight Loss of Taxation: Graphical
Tax Revenue
Supply
$.60
$.50
$.40
Demand
800 1000
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Deadweight Loss of Taxation
The
tax places a wedge between the
price buyers pay and the price sellers
receive. The higher price to buyers
and the lower price to sellers results in
a lower quantity demanded and
quantity supplied.
The loss in quantity demanded and the
quantity supplied is 200 units (1000 800).
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Deadweight Loss of Taxation: Graphical
Supply
$.60
Deadweight
Loss = $20
$.50
$.40
Demand
800 1000
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Deadweight Loss of Taxation, example
The
deadweight loss of 200 units do
no one any good
– The value of the loss to society due to the
twenty cent tax is = $20
($500 $480)
Taxes
cause deadweight losses
because they prevent buyers and
sellers from realizing some of the
gains from trade.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Determinants of Deadweight Loss
The
magnitude of the Deadweight Loss
depends upon how large a decline in
market exchange occurs as a result of
the tax.
The size in the decline in market
exchange depends upon how sensitive
consumers and producers are to
changes in prices: Elasticity Concept.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Determinants of Deadweight Loss
The more elastic demand and
supply are, the greater will be the
decline in equilibrium quantity and
the greater the
Deadweight Loss.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
More Elastic Demand and Supply
S0
PE
D0
QE
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
More Elastic Demand and Supply
S2
Amount
of Tax
S0
PE
D0
QE
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
More Elastic Demand and Supply
S2
Amount
of Tax
P2
S0
PE
D0
Q2
QE
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
More Elastic Demand and Supply
S2
Amount
of Tax
P2
S0
Deadweight
Loss!
PE
D0
Q2
QE
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Determinants of Deadweight Loss
A
tax has a deadweight loss because it
induces buyers and sellers to change
their behaviour.
– Higher prices cause buyers to buy less.
– Lower prices received causes sellers to
offer less.
The
size of the market shrinks below
the optimum.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Less Elastic Demand and Supply
S0
PE
D0
QE
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Less Elastic Demand and Supply
S2
P2
S0
Amount of Tax
PE
D0
Q2 QE
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Less Elastic Demand and Supply
S2
P2
S0
Amount of Tax
Deadweight
Loss!
PE
D0
Q2 QE
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
Deadweight Loss and Tax Revenue
The
deadweight loss of a tax rises
even more rapidly than the size of the
tax.
– It is related to the area of a triangle. If we
double the tax, the size of the triangle
increases four times.
With
each increase in the tax rate, tax
revenues will rise slowly, reach a
maximum, and decline.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
The Costs of Taxation: Conclusion
When
a tax is imposed on a good, the
tax reduces consumer and producer
surplus by an amount that is greater
than the tax revenue generated.
The difference between the decrease
in total consumer and producer
surplus and the tax revenue generated
is referred to as the Deadweight Loss
of a tax.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition
The Costs of Taxation: Conclusion
As
the tax gets larger, the deadweight
loss increases more than
proportionate to the tax increase.
With the increase in the tax rate, the
percentage decrease in market
equilibrium quantity becomes greater.
Tax revenues begin to decrease.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8
First Canadian Edition