Lecture Notes: Econ 203 Introductory Microeconomics Lecture/Chapter 8: The costs of taxation M. Cary Leahey Manhattan College Fall 2012

2 Goals This is another applications chapter looking at taxes. This chapter reviews many of the concepts introduced in earlier classes, particularly the tradeoff between efficiency and equity. We introduce a new concept of dead weight loss to examine the efficiency of a tax.

3 Taxes: a brief review Taxes drive a wedge between prices paid by buyers and offered by sellers. Hence it distortion the market outcome. The tax increases the price paid and received. The tax reduces the quantity bought and sold. The outcome is indifferent to how the tax is levied. But taxes are a “cost of civilization” and are needed to fund the desired operations of government. But good people can differ on the kinds of taxes they want and the kinds of government spending they want.

The effects of a tax P Q D S Revenue from tax: $ T x Q T PSPS PBPB PEPE QEQE QTQT Size of tax = $T

The effects of a tax  Using our knowledge of welfare economics, we measure the gains and losses from a tax.  We determine:  consumer surplus (CS)  producer surplus (PS)  tax revenue  total surplus, which includes the beneficial services paid by the tax.

The effects of a tax P Q D S Without a tax, PEPE QEQE QTQT A B C D E F CS = A + B + C PS = D + E + F Tax revenue = 0 Total surplus = CS + PS = A + B + C + D + E + F

The effects of a tax P Q D S PSPS PBPB QEQE QTQT A B C D E F CS = A PS = F Tax revenue = B + D Total surplus = A + B + D + F With the tax, The tax reduces total surplus by C + E

The effects of a tax P Q D S PSPS PBPB QEQE QTQT A B C D E F C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax.

More on the deadweight loss P Q D S PSPS PBPB QEQE QTQT Because of the tax, the units between Q T and Q E are not sold. The value of these units to buyers is greater than the cost of producing them, so the tax prevents some mutually beneficial trades.

10 Determining the deadweight loss (DWL) One yardstick for figuring out which goods or services to tax is to tax those with the smallest DWL, which this is the smallest distortion relative to the market outcome. The sixe of the DWL depends on the elasticities of supply and demand, the responsiness of supply and demand to price sold and paid.

When supply is inelastic, it’s harder for firms to leave the market when the tax reduces P S. So, the tax only reduces Q a little, and DWL is small. When supply is inelastic, it’s harder for firms to leave the market when the tax reduces P S. So, the tax only reduces Q a little, and DWL is small. DWL and the elasticity of supply P Q D S Size of tax

DWL and the elasticity of supply P Q D S Size of tax The more elastic is supply, the easier for firms to leave the market when the tax reduces P S, the greater Q falls below the surplus- maximizing quantity, the greater the DWL. The more elastic is supply, the easier for firms to leave the market when the tax reduces P S, the greater Q falls below the surplus- maximizing quantity, the greater the DWL.

DWL and the elasticity of demand P Q D S Size of tax When demand is inelastic, it’s harder for consumers to leave the market when the tax raises P B. So, the tax only reduces Q a little, and DWL is small. When demand is inelastic, it’s harder for consumers to leave the market when the tax raises P B. So, the tax only reduces Q a little, and DWL is small.

DWL and the elasticity of demand P Q D S Size of tax The more elastic is demand, the easier for buyers to leave the market when the tax increases P B, the more Q falls below the surplus- maximizing quantity, and the greater the DWL. The more elastic is demand, the easier for buyers to leave the market when the tax increases P B, the more Q falls below the surplus- maximizing quantity, and the greater the DWL.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15 DWL and the elasticity of demand P Q D S Size of tax The more elastic is demand, the easier for buyers to leave the market when the tax increases P B, the more Q falls below the surplus- maximizing quantity, and the greater the DWL. The more elastic is demand, the easier for buyers to leave the market when the tax increases P B, the more Q falls below the surplus- maximizing quantity, and the greater the DWL.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 The proper size of government: discussion  Class discussion. How to fund the needed operations of government-defense, highways etc.  What should be taxed: groceries or restaurant meals?

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 The proper size of government  Bigger government means more services but requires higher taxes and higher DWLs.  The larger the DWLs, the greater the argument for smaller govt.  With labor income taxes the largest single revenue source, the elasticity of labor supply depends the size of the DWL  If labor supply is elastic, then the DWL is large.  If labor supply is inelastic, then the DWL is small.  Size of the elasticity is not just an empirical question but a question of morality to some.  Reasons for high elasticity:  Many workers can adjust hours/are second earners/elderly and don’t “need” the income/work underground

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 Q2Q2 Q1Q1 DWL and the size of the tax P Q D S causes the DWL to more than double. Doubling the tax 2T2T T Initially, the tax is T per unit. initial DWL new DWL

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 Q3Q3 DWL and the size of the tax P Q D S Q1Q1 3T3T T causes the DWL to more than triple. Tripling the tax Initially, the tax is T per unit. initial DWL new DWL

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 DWL and the size of the tax DWL Tax size Summary When a tax increases, DWL rises even more. Implication When tax rates are low, raising them doesn’t cause much harm, and lowering them doesn’t bring much benefit. When tax rates are high, raising them is very harmful, and cutting them is very beneficial. Implication When tax rates are low, raising them doesn’t cause much harm, and lowering them doesn’t bring much benefit. When tax rates are high, raising them is very harmful, and cutting them is very beneficial.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 Q2Q2 DWL and the size of the tax P Q D S Q1Q1 PBPB PSPS PBPB PSPS 2T2T T When the tax is small, increasing it causes tax revenue to rise.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22 Q3Q3 DWL and the size of the tax P Q D S Q2Q2 PBPB PSPS PBPB PSPS 3T3T 2T2T When the tax is larger, increasing it causes tax revenue to fall.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23 The Laffer curve shows the relationship between the size of the tax and tax revenue. DWL and the size of the tax: an extreme example Tax size Tax revenue The Laffer curve

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24 Summary  Taxes reduce the welfare of buyers and sellers. This welfare loss usually exceeds the revenue gain.  The decline in total surplus (consumer surplus and producer surplus and tax revenue) is called the deadweight loss of the tax.  Taxes have deadweight losses because they causes consumer to buy less and seller to sell less, thus shrinking the market.  The size of the DWLs depend on the elasticities of supply and demand. Higher elasticizes imply higher DMLs.  DWLs increases even more than the size of the tax.  In one extreme case, revenue may actually fall as taxes become too large. But this rarely happens in real life.