APPLICATIONS OF WELFARE ECONOMICS: THE COST OF TAXATION

Overview How do taxes affect the economic well-being of market participants? We can use the tools of welfare economics (consumer and producer surplus) to answer that question. In chapter 6 we learned that 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. In this chapter we examine the “Distortions” and welfare losses in markets subject to taxation 2

How a Tax Affects Market Participants A tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax. The size of the market for that good shrinks. As a result, there is a loss in consumer and producer surplus. That loss is known as the deadweight loss of taxation

Deadweight Loss of Taxation A per-unit tax drives a wedge between the price paid by consumers and the price received by suppliers. As a result, output falls as does consumer and producer surplus Price S1 Loss in Consumer Surplus PD P1 Tax Wedge PS Loss in Producer Surplus D1 QTax Q1 Quantity

Deadweight Loss of Taxation Price The area to the left of the tax wedge represents government tax revenue, the area to the right of the tax wedge represents the deadweight loss of taxation S1 PD P1 Tax Revenue Deadweight loss of taxation PS D1 QTax Q1 Quantity

Deadweight Loss of Taxation Price Consumer Surplus without tax: A+B+C Producer Surplus without tax: D+E+F Consumer Surplus with tax: A Producer Surplus with Tax: F Government tax Revenue: B+D Deadweight loss of taxation: C+E S1 A PD B C P1 D E PS F D1 QTax Q1 Quantity

How a Tax Affects Welfare

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

The Magnitude of Deadweight Loss What determines whether the deadweight loss from a tax is large or small? 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.

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

Deadweight Loss: Inelastic Supply & Demand When demand and/or supply is inelastic, the deadweight loss of taxation is small D S Deadweight Loss (DWL) tax P1 Q1 Qt Q

Deadweight Loss: Elastic Supply & Demand When demand and/or supply is elastic, the deadweight loss of taxation is large S D Deadweight Loss (DWL) P1 Q1 tax Qt Q

Deadweight Loss and the Size of a Tax With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax. Doubling the tax rate will more than double the deadweight loss of taxation

Deadweight Loss with a Small Sized Tax P Per Unit Tax D S Tax Revenue PD Deadweight Loss (DWL) P1 Q1 PS Qt Q

Deadweight Loss with a Medium Sized Tax P Per Unit Tax D S Tax Revenue PD Deadweight Loss (DWL) P1 Q1 PS Qt Q

Deadweight Loss with a Large Sized Tax P Per Unit Tax D PD S Tax Revenue P1 Q1 Deadweight Loss (DWL) PS Qt Q

The Relationship Between Deadweight Loss and the Size of a Tax Tax Size