12. Taxation and Economic Efficiency

12.1. Introductory Notes

12.2.Effect of Taxes Borne by Consumers

Equilibrium after imposition of a tax on Beer Soda E  equilibrium before tax is imposed E* equilibrium after tax is imposed Consumption of beer declines Indifferent Curve C E I E* Before tax budget line I* Beer After tax budget line

Substitution and Income Effects Soda E  E* = Total Effect E* E** = Substitution Effect E E** = Income Effect Indifferent Curve E I E* Before tax budget line E** I* Beer Before tax budget line

12.3. Quantifying the Distorting Effects of Taxation on Products

Lump-Sum Tax All other goods Y Lump-sum tax Y* B B* Beer

Measuring Deadweight Loss (1) All other goods Indifferent Curve Revenues with lump-sum tax = Revenues with tax on beer A Y E B Y* B* Lump-sum tax E* Before-tax budget line B B* B** Beer After-tax on beer budget line

Measuring Deadweight Loss (2) All other goods Revenues with tax on beer A Y A* E Y* Revenues with lump-sum tax E* E** Deadweight loss I I* Indifferent Curve B Beer After-tax budget line B* B** Before-tax budget line

Measuring Deadweight Loss Using Compensated Demand Curves Price Deadweight Loss C D Supply Curve Tax t A B E Q1 Quantity A Tax Revenues

Effect of an Increase in Tax Rate on Deadweight Loss Compensated Demand Curves Price Deadweight Loss C Supply Curve Tax 2t C* Tax t E B* B Quantity Tax Revenues

Deadweight Loss of a Tax on Production Price B H Supply Curve C p E P - t Deadweight loss G D Quantity

Deadweight Loss from a Tax is Borne Partly by Consumers and Partly Producers Price Consumers’ deadweight loss is ABD Producers’ deadweight loss is BCE Supply Curve A D Ps E B Demand Curve Tax P C Ps Compensated Demand Curve Q* Q** Q* Q Quantity

12.4.Taxation of Savings

Consumption and Savings Next Period Indifferent Curve between Present and Future Consumption (1+r)C E W W1 Co Wo C Consumption today Saving

Consumption and Borrowing Next Period (1+r)C Indifferent Curve between Present and Future Consumption W W1 E Wo Co C Consumption today Borrowing

Effect of Interest Income Tax Consumption Next Period Before-tax budget constraint EE**= Income effect (IE) E**E* = Substitution effect (SE) IE = SE But, still deadweight loss exist,  E*F (1+r)C E E** E* W1 After-tax budget constraint W F Co Wo Consumption today Budget constraint with lump-tax that leaves individual just as well off as interest income tax

12.5. Taxation of Labor Income

Effect of Wage Taxation Consumption Before-tax budget constraint EE**= Income effect (IE) E**E* = Substitution effect (SE) SE  working time reduces IE  working more But, IE = SE Tax has still deadweight loss  E*F C E E** W1 After-tax budget constraint E* F L Lo Working Leisure

Backward-Bending Labor Supply Curve Net Wage After Tax Wage Labor supply is back-bending only if Income effect (IE) > substitution effect Thus, tax on labor wage may increase labor supply But, tax still has a deadweight loss E2 W1 E1 Wo Before Tax Wage L1  Labor after tax Labor service Lo Labor before tax

12.8. Readings Stiglitz, Joseph E. 2000. Economics of the Public Sector. New York, USA: W.W. Northon and Company. Chapter 19.