Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition 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 u Free markets allocate the supply of goods to the buyers who value them most highly. u Free markets allocate the demand for goods to the sellers who can produce them at least cost. u 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 u 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 u A tax places a wedge between the price buyers pay and the price sellers receive. u A tax results in a Deadweight Loss to society and the economy Tax! Loss!

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition Deadweight Loss of Taxation: Graphical $ Demand Supply

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition Deadweight Loss of Taxation: Graphical $ Demand Supply $.60 $ $.20 tax imposed

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition Deadweight Loss of Taxation: Example u The twenty cent tax results in new prices to consumers and producers: –Consumers pay $0.60 –Sellers receive $0.40 u 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 $ Demand Supply $.60 $ Tax Revenue

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition Deadweight Loss of Taxation u 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. u The loss in quantity demanded and the quantity supplied is 200 units ( ).

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition Deadweight Loss of Taxation: Graphical $ Demand Supply $.60 $ Deadweight Loss = $20

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition Deadweight Loss of Taxation, example u 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) u 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 u The magnitude of the Deadweight Loss depends upon how large a decline in market exchange occurs as a result of the tax. u 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 S0S0 D0D0 QEQE PEPE

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition More Elastic Demand and Supply S0S0 D0D0 QEQE PEPE S2S2 Amount of Tax

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition More Elastic Demand and Supply S0S0 D0D0 QEQE PEPE S2S2 Amount of Tax Q2Q2 P2P2

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition More Elastic Demand and Supply S0S0 D0D0 QEQE PEPE S2S2 Amount of Tax Q2Q2 P2P2 Deadweight Loss!

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition Determinants of Deadweight Loss u 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. u 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 S0S0 D0D0 QEQE PEPE

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition Less Elastic Demand and Supply S0S0 D0D0 QEQE PEPE S2S2 P2P2 Q2Q2 Amount of Tax

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition Less Elastic Demand and Supply S0S0 D0D0 QEQE PEPE S2S2 P2P2 Q2Q2 Amount of Tax Deadweight Loss!

Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition Deadweight Loss and Tax Revenue u 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. u 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 u 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. u 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 u As the tax gets larger, the deadweight loss increases more than proportionate to the tax increase. u With the increase in the tax rate, the percentage decrease in market equilibrium quantity becomes greater. Tax revenues begin to decrease.