1. 12. Taxation and Economic Efficiency

2. 12.1. Introductory Notes

3. 12.2.Effect of Taxes Borne by Consumers

4. Equilibrium after imposition of
a tax on Beer
Soda
E  equilibrium before tax is imposed
E* equilibrium after tax is imposed
Consumption of beer declines
Indifferent Curve C E I E*
Before tax budget line I*
Beer
After tax budget line

5. Substitution and Income Effects
Soda
E  E* = Total Effect
E* E** = Substitution Effect
E E** = Income
Effect
Indifferent Curve E I E*
Before tax budget line
E** I*
Beer
Before tax budget line

6. 12.3. Quantifying the Distorting Effects of Taxation on Products

7. Lump-Sum Tax
All other goods Y
Lump-sum tax Y* B B*
Beer

8. Measuring Deadweight Loss (1)
All other goods
Indifferent Curve
Revenues with lump-sum tax =
Revenues with tax on beer A Y E B Y* B*
Lump-sum tax E*
Before-tax budget line B B*
B**
Beer
After-tax on beer budget line

9. Measuring Deadweight Loss (2)
All other goods
Revenues with tax on beer A Y A* E Y*
Revenues with lump-sum tax E*
E**
Deadweight loss I I*
Indifferent Curve B
Beer
After-tax budget line B*
B**
Before-tax budget line

10. Measuring Deadweight Loss Using Compensated Demand Curves
Price
Deadweight Loss C D
Supply Curve
Tax t A B E Q1
Quantity A
Tax Revenues

11. Effect of an Increase in Tax Rate on Deadweight Loss
Compensated Demand Curves
Price
Deadweight Loss C
Supply Curve
Tax 2t C*
Tax t E B* B
Quantity
Tax Revenues

12. Deadweight Loss of a Tax on Production
Price B H
Supply Curve C p E
P - t
Deadweight loss G D
Quantity

13. Deadweight Loss from a Tax is Borne Partly by Consumers and Partly Producers
Price
Consumers’ deadweight loss is ABD
Producers’ deadweight loss is BCE
Supply Curve A D Ps E B
Demand Curve
Tax P C Ps
Compensated Demand
Curve Q*
Q** Q* Q
Quantity

14. 12.4.Taxation of Savings

15. Consumption and Savings
Next Period
Indifferent Curve between Present and Future Consumption
(1+r)C E W W1 Co Wo C
Consumption today
Saving

16. Consumption and Borrowing
Next Period
(1+r)C
Indifferent Curve between Present and Future Consumption W W1 E Wo Co C
Consumption today
Borrowing

17. Effect of Interest Income Tax
Consumption
Next Period
Before-tax budget constraint
EE**= Income effect (IE)
E**E* = Substitution
effect (SE)
IE = SE
But, still deadweight loss exist,  E*F
(1+r)C E
E** E* W1
After-tax budget constraint W F Co Wo
Consumption today
Budget constraint with lump-tax that leaves individual just as well off as interest income tax

18. 12.5. Taxation of Labor Income

19. Effect of Wage Taxation
Consumption
Before-tax budget constraint
EE**= Income effect (IE)
E**E* = Substitution
effect (SE)
SE  working time reduces
IE  working more
But, IE = SE
Tax has still deadweight loss  E*F C E
E** W1
After-tax budget constraint E* F L Lo
Working
Leisure

20. Backward-Bending Labor Supply Curve
Net Wage
After Tax Wage
Labor supply is back-bending only if Income effect (IE) > substitution effect
Thus, tax on labor wage may increase labor supply
But, tax still has a deadweight loss E2 W1 E1 Wo
Before
Tax Wage
L1  Labor after tax
Labor service
Lo Labor before tax

21. 12.8. Readings
Stiglitz, Joseph E Economics of the Public Sector. New York, USA: W.W. Northon and Company. Chapter 19.