1 Analyzing the Economic Impact of Taxes Module 7

2  Use demand and supply graphs to analyze the economic impact of taxes.  Compare the pre-tax market outcomes and the post-tax market outcomes.  What happens to consumer surplus following the tax?  What happens to producer surplus when a tax is imposed on a good?  Identify the deadweight loss created by a tax.  Determine if a tax is efficient. 2 Objectives

3  A tax can be levied on a buyer or a seller. This means that the government collects the tax directly from the buyer or the seller.  Tax “burden” or “incidence”, on the other hand, refers to who actually bears the tax.  Whether a tax is levied on consumers or producers does not affect the tax incidence. Some Terminology 3

4 4 The end results of a tax are:  Consumers typically pay a higher price for the product and there will be a loss of consumer surplus. net price  The net price received by producers falls and there will be a loss of producer surplus. The net price means the price after paying the tax. Another way of describing “net price” is the revenue net of tax for each unit sold. deadweight loss  There is a deadweight loss because of the tax. This deadweight loss is also called the excess burden of the tax.

5 5 Who actually bears the tax? The tax burden varies depending on how responsive producers and consumers are to the price change caused by the tax.

6 6  Suppose the tax is levied on the seller of a product. This simply means that the government collects the tax directly from the seller.  Graphically, levying a tax on the seller is shown by a vertical or upward shift of the supply curve by the full amount of the tax.

7 7 The price paid by consumers has gone up from $12 to P c but it has not gone up by the full amount of the tax. It has gone up by less than $4. In order to determine how the burden of the tax is shared, we need to trace its effects as it works through the market. Let’s see what happens when we add a demand curve to the graph.

8 8 Example: Example: Suppose the government imposes a unit tax Of $4 in the market for wines. Let S 0 = supply curve before the imposition of the tax. Before Tax Price paid by the consumer $12 Price received by the seller $12 Quantity sold480 units Objective: Compare the pre-tax market outcomes and the post-tax market outcomes

9 9  And now a $4 unit tax is levied on the seller. This is shown by an upwards shift of the supply curve. Objective: Compare the pre-tax market outcomes and the post-tax market outcomes The supply curve shifts up by the full amount of the tax. The distance ef = cs= $4

10 Before taxAfter tax Price paid by the consumer$12$14 Net price received by the seller for every unit sold$12$14 − $4 = $10 Quantity sold480 units360 units Consumer’s burden of the tax -- $14  $12 = $2 Producer’s burden of the tax-- $1  $10=$2 Benefit to government--$4 x 360 = $1,440 Objective: Compare the pre-tax market outcomes and the post-tax market outcomes The price increase to the buyer as a result of the tax The fall in revenue received by the seller for each unit sold. The total tax revenue collected by the government. Tax revenue =unit tax  quantity sold

11 Following the imposition of the tax, supply curve  The supply curve shifts up by the full amount of the tax. consumers  The price paid by consumers has increased. producers  The net price received by producers has decreased. quantity traded  The quantity traded has decreased. government  The government collects tax revenue (a benefit). The effects of a tax: a summary

12 What happens to consumer surplus when a unit tax is imposed on a good? Loss in Consumer Surplus = U + V + W - U = V + W Before tax After tax Price paid by the consumer$12$14 Consumer Surplus (area)U + V + WU Consumer Surplus ($) ½ x 480 x 8 = $1,920 ½ x 360 x 6 = $1,080 Consumer’s burden of the tax --$14-$12 = $2

13 The consumer surplus loss when a unit tax is imposed Loss in Consumer Surplus Loss in Consumer Surplus = V + W = $1,920 - $1,080 = $840 rectangle V OR calculate the loss in consumer surplus by adding the area of the rectangle V triangle W and the area of the triangle W rectangle V Area of rectangle V = 2 x 360 = $720 triangle W Area of triangle W = ½ x 120 x 2 =$120 loss in Consumer Surplus Therefore, loss in Consumer Surplus = $840 Before tax After tax Consumer Surplus (area)U + V + WU Consumer Surplus ($) ½ x 480 x 8 = $1,920 ½ x 360 x 6 = $1,080

14 Loss in Producer Surplus = X + Y +Z – Z = X + Y = X + Y What happens to producer surplus when a unit tax is imposed on a good? Before tax After tax Price received by the producer$12$10 Producer Surplus (area)X + Y + ZZ Producer Surplus ($) ½ x 480 x 8 = $1,920 ½ x 360 x 6 = $1,080 Producer’s burden of the tax --$12-$10 = $2 This is the net price to the seller. The buyer pays $14 but the seller cannot keep this entire amount. $4 must be given to the government

15 Before tax After tax Producer Surplus (area)X + Y + ZZ Producer Surplus ($) ½ x 480 x 8 = $1,920 ½ x 360 x 6 = $1,080 Loss in Producer Surplus Loss in Producer Surplus = X + Y = $1,920 - $1,080 = $840 rectangle X OR calculate the loss in producer surplus by adding the area of the rectangle X triangle Y and the area of the triangle Y rectangle X Area of rectangle X = 2  360 = $720 triangle Y Area of triangle Y = ½  120  2 =$120 loss in Producer Surplus Therefore, loss in Producer Surplus = $840 The producer surplus loss when a unit tax is imposed

16 The deadweight loss of a tax deadweight loss  The deadweight loss to society is a measure of the inefficiency of a tax. It arises because:: 1. the tax drives up the price of the good and lowers the quantity sold (360 units instead of 480 units). 2. For the last unit sold, the marginal benefit ($14)  the marginal cost ($10). Marginal cost of the last unit sold Marginal benefit of the last unit sold

17 Before Tax After Tax Consumer Surplus U +V + WULoss = V + W Producer Surplus X + Y + ZZLoss = X + Y Benefit to Government 0V + XGain = V + X Economic Surplus U + V + W + X + Y + Z U + V + X + ZDeadweight loss = W + Y tax revenue  Part of the consumer surplus loss and producer surplus loss goes to the government in the form of tax revenue (area V + X). deadweight loss  What about the area W+Y? No one gets this. This is a deadweight loss. Determining the deadweight loss of a tax

18 Identifying the deadweight loss on a graph Consumer surplus transferred to government Producer surplus transferred to government Deadweight loss

19  Since a tax creates a deadweight loss, does this mean that it is never a good idea for a government to raise revenues by taxing products?  No, not necessarily. In fact, a tax is considered efficient if the deadweight loss is small relative to the tax revenue raised.  In our example, the deadweight loss = W + Y = $240 and the tax revenue = V + X = $1,440. The deadweight loss is relatively small and therefore this tax is considered efficient. Should the government impose a tax despite the deadweight loss created?