APPLICATION: THE COSTS OF TAXATION A.S.Akat EC101 – Chapter 8 APPLICATION: THE COSTS OF TAXATION Chapter 8 1

What we learn in this chapter? A.S.Akat EC101 – Chapter 8 What we learn in this chapter? Welfare economics use the concept of surplus to evaluate the markets We developed three definitions: consumer surplus, producer surplus and total surplus Free and competitive markets maximise total surplus for the society through better allocation of scarce resources In Ch.8 we put our knowledge to practical use in order have important insights about some economic issues and policies Our task is to analyse the effects of taxes on market efficiency 2

Taxation is an important issue A.S.Akat EC101 – Chapter 8 Taxation is an important issue Why do we start with taxes? Taxes are as old as the history of society Ever since governments and states came into existence, they have taxed people in order to pay for their expenses We find the demands of the people to be represented when taxes are levied in the origins of political democracy Taxation remains a major issue in the elections for all democratic countries Tax issues have also been at the forefront of the current elections in Turkey 2

The cost of taxation Governments levy taxes in order to get revenue A.S.Akat EC101 – Chapter 8 The cost of taxation Governments levy taxes in order to get revenue How do taxes affect the economic well-being of market participants? The well-being of buyers and sellers will be lower while the well-being of government higher after the tax is paid This is the commonsense view of taxation Total well-being is redistributed among buyers, seller and the government In other words, the well-being that is lost by the buyers and sellers is recovered by the government as tax revenue 2

Deadweight loss Welfare economics offer a different analysis A.S.Akat EC101 – Chapter 8 Deadweight loss Welfare economics offer a different analysis We already established that when the government levies a tax on a good, the equilibrium quantity of the good is lower than before tax Taxes reduce the size of the market for that good Buyers and sellers loose well-being from the tax and the government earns tax revenue But the losses to buyers and sellers is bigger than the tax revenue of the government This excess of loss is called a deadweight loss Deadweight loss is due to a reduction in total surplus because of the tax 2

The costs of taxation A.S.Akat EC101 – Chapter 8 Price buyers pay Size of tax (T) Quantity sold (Q) Tax revenue (T X Q) with tax Price Price sellers receive without tax Demand Supply 9

Deadweight loss of taxation: an example A.S.Akat EC101 – Chapter 8 Deadweight loss of taxation: an example Price A Supply 0.60 B C 0.50 E D 0.40 F Demand 800 1000 Quantity 14

Deadweight loss of taxation A.S.Akat EC101 – Chapter 8 Deadweight loss of taxation - - + -

Deadweight loss calculated A.S.Akat EC101 – Chapter 8 Deadweight loss calculated Let us look at the example above to calculate the deadweight loss Tax revenue from the tax is equal to unit tax rate multiplied by quantity sold Tax x quantity = ($0.60-$0.40) x 800 = $160 Because the tax places a wedge between the price buyers pay and the price seller receive, this lowers quantity sold by 200 units (1000 - 800) Total turnover in the market fell by 20 $ from 500 $ to 480 $ because of the tax The loss to society due to 0.20 $ tax is the area of a triangle ($20) 15

Why is there deadweight loss? A.S.Akat EC101 – Chapter 8 Why is there deadweight loss? Deadweight loss is a very important concept for economists It breaks the commonsense belief that what some lose is always gained by others Deadweight loss means everybody looses Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade The problem is that loss in well-being caused by the decrease in the quantity sold is not captured by the government as tax revenues Thus becoming a deadweight loss 20

Lost gains from trade Cost to sellers Value to buyers A.S.Akat EC101 – Chapter 8 Price Supply Lost gains from trade P B Size of tax Price without tax P S Cost to sellers Demand Value to buyers Q2 Q1 Quantity Reduction in quantity due to the tax 4

Determinants of deadweight loss A.S.Akat EC101 – Chapter 8 Determinants of deadweight loss A tax has a deadweight loss because it induces buyers and sellers to change their behavior Higher prices cause buyers to buy less Lower prices cause sellers to offer less The size of the market shrinks below the optimum The magnitude of the deadweight loss depends on the decline in market size as a result of the tax That, in turn, depends on the price elasticities of supply and demand The more elastic are demand and supply, the larger will be the decline in equilibrium quantity and the larger the deadweight loss resulting for the tax 21

Tax distortions and elasticity A.S.Akat EC101 – Chapter 8 Tax distortions and elasticity (a) Inelastic Supply (b) Elastic Supply Price Quantity Demand Supply Size of tax When supply is relatively inelastic, the deadweight loss of a tax is small. When supply is relatively elastic, the deadweight loss of a tax is large. 23

Tax distortions and elasticity A.S.Akat EC101 – Chapter 8 Tax distortions and elasticity Demand Supply (c) Inelastic Demand (d) Elastic Demand Price Quantity Size of tax When demand is relatively elastic, the deadweight loss of a tax is large. When demand is relatively inelastic, the deadweight loss of a tax is small. 24

Deadweight loss and tax revenue A.S.Akat EC101 – Chapter 8 Deadweight loss and tax revenue The deadweight loss of a tax rises even more rapidly than the size of the tax 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 then decline This interesting relation between the tax rate and tax revenue is summarised in the Laffer curve Increases in tax rates first increase tax revenues but after a certain ceiling tax revenues fall as tax rates continue to increase Governments must keep the Laffer curve in mind when they set tax rates 31

Supply-side economics A.S.Akat EC101 – Chapter 8 Supply-side economics Some economists believe that high taxes discourage people to put more efforts in order to gain a higher income or take bigger risks Supply-side economics contend that lower tax rates will increase tax revenues due of the higher economic activity resulting from tax cuts This is in line with the Laffer curve In the 1980s the Reagan administration in the US put supply-side economics into practice Tax rates were substantially reduced while government spending remained unchanged The result was large budget deficits because taxe revenues fell despite the claims of supply-siders 31

Deadweight loss and tax revenue A.S.Akat EC101 – Chapter 8 Deadweight loss and tax revenue Small Tax Price Supply Deadweight loss PB Tax revenue PS Demand Q2 Q1 Quantity 31

Deadweight loss and tax revenue A.S.Akat EC101 – Chapter 8 Deadweight loss and tax revenue Large Tax Price PB Supply Deadweight loss Tax revenue Demand PS Q2 Q1 Quantity 31

Deadweight loss and tax revenue A.S.Akat EC101 – Chapter 8 Deadweight loss and tax revenue Medium Tax Price Supply Deadweight loss PB Tax revenue PS Demand Q2 Q1 Quantity 31

The Laffer curve and supply-side economics A.S.Akat EC101 – Chapter 8 The Laffer curve and supply-side economics (a) Revenue (the Laffer curve) (b) Deadweight Loss Tax Revenue Deadweight Loss Tax Size Tax Size 8

A.S.Akat EC101 – Chapter 8 Conclusion A tax on a good 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 called the deadweight loss of a tax The deadweight loss of a tax depends on the price elasticities of demand and supply As the tax rate becomes bigger, its deadweight loss also grows bigger Tax revenue first rises with the size of a tax; but then, as the tax gets larger, the market shrinks so much that tax revenue starts to fall 32