Deadweight Loss and Taxes
Governments have many powers to
affect welfare but each power involves
choices about who wins and who looses
as a result.
Taxes tend to spread the losses
across society in general through
the “social climate”.
Prescriptions have direct effects
on specific sectors and as such
deal with the “business climate”.
Taxes are a distortion
• Taxes and subsidies distort the market and produce
what is called deadweight loss because it removes
from the market economic surplus that would
otherwise benefit consumers and employ resources for
production.
• The deadweight loss depends on the elasticities of
supply and demand and therefore as to whether or
consumers or producers “win” or “loose”.
• However Suppliers also win or loose and it is the
relative impact on suppliers that may have the most
profound economic impact.
Deadweight Loss
•
Deadweight Loss is calculated as Surplus Before less Surplus After for Producers and for Consumers in total. This is economic
surplus that cannot be recovered after the tax. Suppliers also loose but it is assumed that they are able to find markets in
other sectors and are not part of the deadweight loss.
Price
Consumer
Surplus After
Supply
Consumer
Surplus Before
Price with tax
Producer
Surplus Before
Price before tax
Producer
Surplus After
Supplier
Surplus Before
Supplier
Surplus After
Quantity with tax
Quantity without tax
Demand
Quantity
Elasticities Determine “winners” and “losers”.
As demand becomes more inelastic CS falls and taxes are ineffective because consumers
substitute out of the market and suppliers follow.
As supply becomes more elastic PS rises and taxes are ineffective because producers cannot
change production and suppliers are cut out of the market.
Only when demand and supply are measurably elastic will there be a long term deadweight loss.
Price
Measurably Elastic
Demand
Perfectly Elastic Demand
Measurably Elastic Supply
Perfectly Inelastic Demand
Perfectly Elastic Supply
Quantity
Perfectly Inelastic Supply
Governments Perspective on
Deadweight Losses
• Tax revenue may “capture” the deadweight loss and
the government can then redistribute the wealth in a
socially responsible way which the market would not.
• Deadweight losses are dependent on elasticities and
the government may be able to change the elasticity
of demand by:
– Education and public awareness making demand more
inelastic.
– Research and development efforts making supply more
inelastic.
– Using prescriptions to “block out” a market.
Making Demand Inelastic
•
•
When demand is relatively inelastic the deadweight loss of a tax is relatively small.
When demand is relatively elastic the deadweight loss of a tax is relatively Large.
Deadweight Loss
Is relatively small
Supply
Deadweight Loss
Is relatively large
Demand
Demand
Inelastic Demand
Supply
Elastic Demand
Making Supply Inelastic
•
•
When supply is relatively inelastic the deadweight loss of a tax is relatively small.
When supply is relatively elastic the deadweight loss of a tax is relatively Large.
Deadweight Loss
Is relatively small
Deadweight Loss
Is relatively large
Supply
Supply
Demand
Demand
Inelastic Supply
Elastic Supply
Blocking Out a Market
•
When Demand and Supply are inelastic the market is blocked out, as would be done by a benevolent
social planner so taxes would not be needed and Total Revenue is fixed for all markets including supply
markets
Inlastic Demand
Total Revenue is fixed.
Inelastic Supply
The Public Policy Debate
•
Taxes force consumers to prioritize expenditure and in the long run this may lead to abandoning a market
entirely. As tax rates increase the deadweight loss increases at an increasing arte. As the tax rate increases
though the revenue increases and then decreases. There is a tax rate and level of welfare loss beyond
which deadweight losses are not recoverable.
Tax Revenue
Deadweight Loss
$
Deadweight Loss
Redistribution Level
Tax Revenue
Tax Size Percentage
Tax Burden Rate
Tax Limits
• There are limits to taxation that will preserve a market.
Governments generally view this as the level above
which they cannot redistribute welfare losses caused
by taxation.
• The business climate in a free market economy with
democratic freedoms allow for information to be
widely understood by all members of society.
• Even though surpluses may be manipulated they are
never eliminated and when taxes are removed or
government prescriptions are relaxed the surpluses
are re-instated.