Principles of Micro Chapter 8: “Application: The Cost of Taxation” by Tanya Molodtsova, Fall 2005

We Will Learn: taxes reduce consumer and producer surplus taxes reduce consumer and producer surplus the meaning and causes of the deadweight loss from a tax the meaning and causes of the deadweight loss from a tax why some taxes have larger deadweight losses than others why some taxes have larger deadweight losses than others how tax revenue and deadweight loss vary with the size of a tax how tax revenue and deadweight loss vary with the size of a tax

The Deadweight Loss of Taxation Buyers and sellers receive benefits from taking part in the market. Buyers and sellers receive benefits from taking part in the market. The total welfare of buyers and sellers is maximized in equilibrium The total welfare of buyers and sellers is maximized in equilibrium How do taxes affect the economic well-being of market participants? How do taxes affect the economic well-being of market participants?

The Deadweight Loss of Taxation It does not matter whether a tax on a good is levied on buyers or sellers of the good... the price paid by buyers rises, and the price received by sellers falls. It does not matter whether a tax on a good is levied on buyers or sellers of the good... the price paid by buyers rises, and the price received by sellers falls.

The Effect of a Tax Size of tax Quantity 0 Price Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax

How a Tax Affects Market Participants A tax places a wedge between the price buyers pay and the price sellers receive. A tax places a wedge between the price buyers pay and the price sellers receive. the quantity sold falls below the level that would be sold without a tax. the quantity sold falls below the level that would be sold without a tax. The size of the market for that good shrinks The size of the market for that good shrinks

How a Tax Affects Market Participants Tax Revenue Tax Revenue T = the size of the tax T = the size of the tax Q = the quantity of the good sold Q = the quantity of the good sold T  Q = the government’s tax revenue

Tax Revenue Tax revenue (T × Q) Size of tax (T ) Quantity sold (Q) Quantity 0 Price Demand Supply Quantity without tax Quantity with tax Price buyers pay Price sellers receive

How a Tax Affects Welfare A F B D C E Quantity 0 Price Demand Supply = PBPB Q2Q2 = PSPS Price buyers pay Price sellers receive = P1P1 Q1Q1 Price without tax

How a Tax Affects Welfare Welfare Before a Tax: Welfare Before a Tax: Consumer surplus = A + B + C. Producer surplus = D + E + F. Total surplus = A+ B+ C+ D+ E+F. Welfare After Tax: Welfare After Tax: Consumer surplus = A. Producer surplus = F. Tax revenue = B + D. Total surplus = A + B + D + F.

How a Tax Affects Welfare Total surplus decreases by C+E Total surplus decreases by C+E deadweight loss: the fall in total surplus that results from a market distortion, such as a tax. deadweight loss: the fall in total surplus that results from a market distortion, such as a tax.

How a Tax Affects Welfare The change in total welfare includes: The change in total welfare includes: The change in consumer surplus, The change in consumer surplus, The change in producer surplus, and The change in producer surplus, and The change in tax revenue. The change in tax revenue. The losses to buyers and sellers exceed the revenue raised by the government. The losses to buyers and sellers exceed the revenue raised by the government. This fall in total surplus is called the deadweight loss. This fall in total surplus is called the deadweight loss.

Deadweight Losses and the Gains from Trade Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade. Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.

The Deadweight Loss Cost to sellers Value to buyers Size of tax Quantity 0 Demand Supply Lost gains from trade Reduction in quantity due to the tax Price without tax Q1Q1 PBPB Q2Q2 PSPS

The Determinants of the Deadweight Loss The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price. The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price. That, in turn, depends on the price elasticities of supply and demand. That, in turn, depends on the price elasticities of supply and demand.

Tax Distortions and Elasticities Price 0Quantity Demand Supply Size of tax When supply is relatively inelastic, the deadweight loss of a tax is small. (a) Inelastic Supply

Tax Distortions and Elasticities (b) Elastic Supply Price 0 Quantity Demand Supply Size of tax When supply is relatively elastic, the deadweight loss of a tax is large.

Tax Distortions and Elasticities Demand Supply (c) Inelastic Demand Price 0 Quantity Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small.

Tax Distortions and Elasticities (d) Elastic Demand Price 0 Quantity Size of tax Demand Supply When demand is relatively elastic, the deadweight loss of a tax is large.

The Determinants of the Deadweight Loss The greater the elasticities of demand and supply: The greater the elasticities of demand and supply: the larger will be the decline in quantity sold and, the larger will be the decline in quantity sold and, the greater the deadweight loss of a tax. the greater the deadweight loss of a tax.

Case Study: The Deadweight Loss Debate Some economists argue that labor taxes are highly distorting and believe that labor supply is elastic. Some economists argue that labor taxes are highly distorting and believe that labor supply is elastic. Some examples of workers who may respond more to incentives: Some examples of workers who may respond more to incentives: Workers who can adjust the number of hours they work Workers who can adjust the number of hours they work Families with second earners Families with second earners Elderly who can choose when to retire Elderly who can choose when to retire Workers in the underground economy (i.e., those engaging in illegal activity) Workers in the underground economy (i.e., those engaging in illegal activity)

Deadweight Loss and Tax Revenue as Taxes Vary As taxes increase, the deadweight loss from the tax increases. As taxes increase, the deadweight loss from the tax increases. In fact, as taxes increase, the deadweight loss rises more quickly than the size of the tax. In fact, as taxes increase, the deadweight loss rises more quickly than the size of the tax. 1. The deadweight loss is the area of a triangle. 2. If we double the size of a tax, the base and height of the triangle both double so the area of the triangle (the deadweight loss) rises by a factor of four.

Deadweight Loss and Tax Revenue as Taxes Vary Tax revenue Demand Supply Quantity 0 Price Q1Q1 (a) Small Tax Deadweight loss PBPB Q2Q2 PSPS

Deadweight Loss and Tax Revenue as Taxes Vary Tax revenue Quantity 0 Price (b) Medium Tax PBPB Q2Q2 PSPS Supply Demand Q1Q1 Deadweight loss

Deadweight Loss and Tax Revenue as Taxes Vary Tax revenue Demand Supply Quantity 0 Price Q1Q1 PBPB Q2Q2 PSPS Deadweight loss (c) Large Tax

Deadweight Loss and Tax Revenue as Taxes Vary For the small tax, tax revenue is small. For the small tax, tax revenue is small. As the size of the tax rises, tax revenue grows. As the size of the tax rises, tax revenue grows. But as the size of the tax continues to rise, tax revenue falls because the higher tax reduces the size of the market. But as the size of the tax continues to rise, tax revenue falls because the higher tax reduces the size of the market.

Deadweight Loss and Tax Revenue as Taxes Vary (a) Deadweight Loss Deadweight Loss 0 Tax Size

Deadweight Loss and Tax Revenue as Taxes Vary (b) Revenue (the Laffer curve) Tax Revenue 0 Tax Size

Deadweight Loss and Tax Revenue as Taxes Vary As the size of a tax increases, its deadweight loss quickly gets larger. As the size of a tax increases, its deadweight loss quickly gets larger. By contrast, 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. By contrast, 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.

Case Study: The Laffer Curve and Supply-Side Economics The Laffer curve depicts the relationship between tax rates and tax revenue. The Laffer curve depicts the relationship between tax rates and tax revenue. Supply-side economics refers to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues Supply-side economics refers to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues

Summary A tax on a good reduces the welfare of buyers and sellers of the good, and the reduction in consumer and producer surplus usually exceeds the revenues raised by the government. A tax on a good reduces the welfare of buyers and sellers of the good, and the reduction in consumer and producer surplus usually exceeds the revenues raised by the government. The fall in total surplus—the sum of consumer surplus, producer surplus, and tax revenue — is called the deadweight loss of the tax. The fall in total surplus—the sum of consumer surplus, producer surplus, and tax revenue — is called the deadweight loss of the tax.

Summary Taxes have a deadweight loss because they cause buyers to consume less and sellers to produce less. Taxes have a deadweight loss because they cause buyers to consume less and sellers to produce less. This change in behavior shrinks the size of the market below the level that maximizes total surplus. This change in behavior shrinks the size of the market below the level that maximizes total surplus.

Summary As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. Tax revenue first rises with the size of a tax. Tax revenue first rises with the size of a tax. Eventually, however, a larger tax reduces tax revenue because it reduces the size of the market. Eventually, however, a larger tax reduces tax revenue because it reduces the size of the market.