1. Analyzing the Economic Impact of Taxes
Module 7
Analyzing the Economic Impact of Taxes

2. Use demand and supply graphs to analyze the economic impact of taxes.
Objectives
Use demand and supply graphs to analyze the economic impact of taxes. 2

3. Objectives
Use demand and supply graphs to analyze the economic impact of taxes.
Compare the pre-tax market outcomes and the post-tax market outcomes. 3

4. Objectives
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? 4

5. Objectives
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? 5

6. Objectives
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. 6

7. Objectives
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. 7

8. Some Terminology
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. 8

9. Some Terminology
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. 9

10. Some Terminology
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. 10

11. 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. 11

12. 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.
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. 12

13. 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.
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.
There is a deadweight loss because of the tax. This deadweight loss is also called the excess burden of the tax. 13

14. Who actually bears the tax?14

15. 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. 15

16. Suppose the tax is levied on the seller of a product
Suppose the tax is levied on the seller of a product. This simply means that the government collects the tax directly from the seller. 16

17. Suppose the tax is levied on the seller of a product
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. 17

18. Suppose the tax is levied on the seller of a product
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. 18

19. In order to determine how the burden of the tax is shared, we need to trace its effects as it works through the market. 19

20. Let’s see what happens when we add a demand curve to the graph.
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. 20

21. Let’s see what happens when we add a demand curve to the graph.
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.
The price paid by consumers has gone up from $12 to Pc but it has not gone up by the full amount of the tax. It has gone up by less than $4. 21

22. Objective: Compare the pre-tax market outcomes and the post-tax market outcomes
Example: Suppose the government imposes a unit tax
of $4 in the market for wines. 22

23. Objective: Compare the pre-tax market outcomes and the post-tax market outcomes
Example: Suppose the government imposes a unit tax
Of $4 in the market for wines.
Let S0 = supply curve before the imposition of the tax. 23

24. Objective: Compare the pre-tax market outcomes and the post-tax market outcomes
Example: Suppose the government imposes a unit tax
Of $4 in the market for wines.
Let S0 = supply curve before the imposition of the tax.
Before Tax
Price paid by the consumer
$12
Price received by the seller
Quantity sold
480 units 24

25. Objective: Compare the pre-tax market outcomes and the post-tax market outcomes
And now a $4 unit tax is levied on the seller. This is shown by an upwards shift of the supply curve.
The supply curve shifts up by the full amount of the tax. The distance
ef = cs= $4 25

26. Objective: Compare the pre-tax market outcomes and the post-tax market outcomes
Before tax
After tax
Price paid by the consumer
$12
$14
Net price received by the seller
for every unit sold
$14 − $4 = $10
Quantity sold
480 units
360 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
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 26

27. The effects of a tax: a summary
Following the imposition of the tax,
The supply curve shifts up by the full amount
of the tax. 27

28. The effects of a tax: a summary
Following the imposition of the tax,
The supply curve shifts up by the full amount
of the tax.
The price paid by consumers has increased. 28

29. The effects of a tax: a summary
Following the imposition of the tax,
The supply curve shifts up by the full amount
of the tax.
The price paid by consumers has increased.
The net price received by producers has decreased. 29

30. The effects of a tax: a summary
Following the imposition of the tax,
The supply curve shifts up by the full amount
of the tax.
The price paid by consumers has increased.
The net price received by producers has decreased.
The quantity traded has decreased. 30

31. The effects of a tax: a summary
Following the imposition of the tax,
The supply curve shifts up by the full amount
of the tax.
The price paid by consumers has increased.
The net price received by producers has decreased.
The quantity traded has decreased.
The government collects tax revenue (a benefit). 31

32. What happens to consumer surplus when a unit tax is imposed on a good?32

33. What happens to consumer surplus when a unit tax is imposed on a good?
Before tax
After tax
Price paid by the consumer
$12
$14
Consumer Surplus (area)
U + V + W U
Consumer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Consumer’s burden of the tax --
$14-$12 = $2 33

34. What happens to consumer surplus when a unit tax is imposed on a good?
Before tax
After tax
Price paid by the consumer
$12
$14
Consumer Surplus (area)
U + V + W U
Consumer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Consumer’s burden of the tax --
$14-$12 = $2
Loss in Consumer
Surplus = U + V + W - U
= V + W 34

35. The consumer surplus loss when a unit tax is imposed
Before tax
After tax
Consumer Surplus (area)
U + V + W U
Consumer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Loss in Consumer Surplus = V + W
= $1,920 - $1,080
= $840 35

36. The consumer surplus loss when a unit tax is imposed
Before tax
After tax
Consumer Surplus (area)
U + V + W U
Consumer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Loss in Consumer Surplus = V + W
= $1,920 - $1,080
= $840
OR calculate the loss in consumer surplus by adding the area of the rectangle V
and the area of the triangle W 36

37. The consumer surplus loss when a unit tax is imposed
Before tax
After tax
Consumer Surplus (area)
U + V + W U
Consumer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Loss in Consumer Surplus = V + W
= $1,920 - $1,080
= $840
OR calculate the loss in consumer surplus by adding the area of the rectangle V
and the area of the triangle W
Area of rectangle V = 2 x 360 = $720 37

38. The consumer surplus loss when a unit tax is imposed
Before tax
After tax
Consumer Surplus (area)
U + V + W U
Consumer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Loss in Consumer Surplus = V + W
= $1,920 - $1,080
= $840
OR calculate the loss in consumer surplus by adding the area of the rectangle V
and the area of the triangle W
Area of rectangle V = 2 x 360 = $720
Area of triangle W = ½ x 120 x 2 =$120 38

39. The consumer surplus loss when a unit tax is imposed
Before tax
After tax
Consumer Surplus (area)
U + V + W U
Consumer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Loss in Consumer Surplus = V + W
= $1,920 - $1,080
= $840
OR calculate the loss in consumer surplus by adding the area of the rectangle V
and the area of the triangle W
Area of rectangle V = 2 x 360 = $720
Area of triangle W = ½ x 120 x 2 =$120
Therefore, loss in Consumer Surplus = $840 39

40. What happens to producer surplus when a unit tax is imposed on a good?
Before tax
After tax
Price received by the producer
$12
$10
Producer Surplus (area)
X + Y + Z Z
Producer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Producer’s burden of the tax --
$12-$10 = $2 40

41. What happens to producer surplus when a unit tax is imposed on a good?
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
Before tax
After tax
Price received by the producer
$12
$10
Producer Surplus (area)
X + Y + Z Z
Producer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Producer’s burden of the tax --
$12-$10 = $2 41

42. What happens to producer surplus when a unit tax is imposed on a good?
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
Before tax
After tax
Price received by the producer
$12
$10
Producer Surplus (area)
X + Y + Z Z
Producer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Producer’s burden of the tax --
$12-$10 = $2
Loss in Producer
Surplus = X + Y +Z – Z
= X + Y 42

43. The producer surplus loss when a unit tax is imposed
Before tax
After tax
Producer Surplus (area)
X + Y + Z Z
Producer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Loss in Producer Surplus = X + Y
= $1,920 - $1,080
= $840 43

44. The producer surplus loss when a unit tax is imposed
Before tax
After tax
Producer Surplus (area)
X + Y + Z Z
Producer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Loss in Producer Surplus = X + Y
= $1,920 - $1,080
= $840
OR calculate the loss in producer surplus by adding the area of the rectangle X
and the area of the triangle Y 44

45. The producer surplus loss when a unit tax is imposed
Before tax
After tax
Producer Surplus (area)
X + Y + Z Z
Producer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Loss in Producer Surplus = X + Y
= $1,920 - $1,080
= $840
OR calculate the loss in producer surplus by adding the area of the rectangle X
and the area of the triangle Y
Area of rectangle X = 2  360 = $720 45

46. The producer surplus loss when a unit tax is imposed
Before tax
After tax
Producer Surplus (area)
X + Y + Z Z
Producer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Loss in Producer Surplus = X + Y
= $1,920 - $1,080
= $840
OR calculate the loss in producer surplus by adding the area of the rectangle X
and the area of the triangle Y
Area of rectangle X = 2  360 = $720
Area of triangle Y = ½  120  2 =$120 46

47. The producer surplus loss when a unit tax is imposed
Before tax
After tax
Producer Surplus (area)
X + Y + Z Z
Producer Surplus ($)
½ x 480 x 8
= $1,920
½ x 360 x 6
= $1,080
Loss in Producer Surplus = X + Y
= $1,920 - $1,080
= $840
OR calculate the loss in producer surplus by adding the area of the rectangle X
and the area of the triangle Y
Area of rectangle X = 2  360 = $720
Area of triangle Y = ½  120  2 =$120
Therefore, loss in Producer Surplus = $840 47

48. Determining the deadweight loss of a tax
Before Tax
After Tax
Consumer Surplus
U +V + W U
Loss = V + W
Producer Surplus
X + Y + Z Z
Loss = X + Y
Benefit to Government
V + X
Gain = V + X
Economic Surplus
U + V + W + X + Y + Z
U + V + X + Z
Deadweight loss = W + Y
Part of the consumer surplus loss and producer surplus loss goes to the government in the form of tax revenue (area V + X).
What about the area W+Y? No one gets this. This is a deadweight loss. 48

49. Identifying the deadweight loss on a graph49

50. Identifying the deadweight loss on a graph
Consumer surplus transferred to government 50

51. Identifying the deadweight loss on a graph
Consumer surplus transferred to government
Deadweight loss 51

52. Identifying the deadweight loss on a graph
Consumer surplus transferred to government
Deadweight loss
Producer surplus transferred to government 52

53. Identifying the deadweight loss on a graph
Consumer surplus transferred to government
Deadweight loss
Producer surplus transferred to government 53

54. The deadweight loss of a tax
The deadweight loss to society is a measure of the inefficiency of a tax. 54

55. The deadweight loss of a tax
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). 55

56. The deadweight loss of a tax
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 benefit of the last unit sold
Marginal cost of the last unit sold 56

57. Should the government impose a tax despite the deadweight loss created?
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? 57

58. Should the government impose a tax despite the deadweight loss created?
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. 58

59. Should the government impose a tax despite the deadweight loss created?
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. 59