1. APPLICATION: THE COSTS OF TAXATION
A.S.Akat
EC101 – Chapter 8
APPLICATION: THE COSTS OF TAXATION
Chapter 8 1

2. What we learn in this chapter?
A.S.Akat
EC101 – Chapter 8
What we learn in this chapter?
Welfare economics use the concept of surplus to evaluate the markets
We developed three definitions: consumer surplus, producer surplus and total surplus
Free and competitive markets maximise total surplus for the society through better allocation of scarce resources
In Ch.8 we put our knowledge to practical use in order have important insights about some economic issues and policies
Our task is to analyse the effects of taxes on market efficiency 2

3. Taxation is an important issue
A.S.Akat
EC101 – Chapter 8
Taxation is an important issue
Why do we start with taxes?
Taxes are as old as the history of society
Ever since governments and states came into existence, they have taxed people in order to pay for their expenses
We find the demands of the people to be represented when taxes are levied in the origins of political democracy
Taxation remains a major issue in the elections for all democratic countries
Tax issues have also been at the forefront of the current elections in Turkey 2

4. The cost of taxation Governments levy taxes in order to get revenue
A.S.Akat
EC101 – Chapter 8
The cost of taxation
Governments levy taxes in order to get revenue
How do taxes affect the economic well-being of market participants?
The well-being of buyers and sellers will be lower while the well-being of government higher after the tax is paid
This is the commonsense view of taxation
Total well-being is redistributed among buyers, seller and the government
In other words, the well-being that is lost by the buyers and sellers is recovered by the government as tax revenue 2

5. Deadweight loss Welfare economics offer a different analysis
A.S.Akat
EC101 – Chapter 8
Deadweight loss
Welfare economics offer a different analysis
We already established that when the government levies a tax on a good, the equilibrium quantity of the good is lower than before tax
Taxes reduce the size of the market for that good
Buyers and sellers loose well-being from the tax and the government earns tax revenue
But the losses to buyers and sellers is bigger than the tax revenue of the government
This excess of loss is called a deadweight loss
Deadweight loss is due to a reduction in total surplus because of the tax 2

6. The costs of taxation A.S.Akat EC101 – Chapter 8 Price buyers pay
Size of tax (T)
Quantity
sold (Q)
Tax
revenue
(T X Q)
with tax
Price
Price sellers
receive
without tax
Demand
Supply 9

7. Deadweight loss of taxation: an example
A.S.Akat
EC101 – Chapter 8
Deadweight loss of taxation: an example
Price A
Supply
0.60 B C
0.50 E D
0.40 F
Demand
800
1000
Quantity 14

8. Deadweight loss of taxation
A.S.Akat
EC101 – Chapter 8
Deadweight loss of taxation - - + -

9. Deadweight loss calculated
A.S.Akat
EC101 – Chapter 8
Deadweight loss calculated
Let us look at the example above to calculate the deadweight loss
Tax revenue from the tax is equal to unit tax rate multiplied by quantity sold
Tax x quantity = ($0.60-$0.40) x 800 = $160
Because the tax places a wedge between the price buyers pay and the price seller receive, this lowers quantity sold by 200 units ( )
Total turnover in the market fell by 20 $ from 500 $ to 480 $ because of the tax
The loss to society due to 0.20 $ tax is the area of a triangle ($20) 15

10. Why is there deadweight loss?
A.S.Akat
EC101 – Chapter 8
Why is there deadweight loss?
Deadweight loss is a very important concept for economists
It breaks the commonsense belief that what some lose is always gained by others
Deadweight loss means everybody looses
Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade
The problem is that loss in well-being caused by the decrease in the quantity sold is not captured by the government as tax revenues
Thus becoming a deadweight loss 20

11. Lost gains from trade Cost to sellers Value to buyers
A.S.Akat
EC101 – Chapter 8
Price
Supply
Lost gains
from trade P B
Size of tax
Price
without tax P S
Cost to
sellers
Demand
Value to
buyers Q2 Q1
Quantity
Reduction in quantity due to the tax 4

12. Determinants of deadweight loss
A.S.Akat
EC101 – Chapter 8
Determinants of deadweight loss
A tax has a deadweight loss because it induces buyers and sellers to change their behavior
Higher prices cause buyers to buy less
Lower prices cause sellers to offer less
The size of the market shrinks below the optimum
The magnitude of the deadweight loss depends on the decline in market size as a result of the tax
That, in turn, depends on the price elasticities of supply and demand
The more elastic are demand and supply, the larger will be the decline in equilibrium quantity and the larger the deadweight loss resulting for the tax 21

13. Tax distortions and elasticity
A.S.Akat
EC101 – Chapter 8
Tax distortions and elasticity
(a) Inelastic Supply
(b) Elastic Supply
Price
Quantity
Demand
Supply
Size of
tax
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
When supply is relatively
elastic, the deadweight
loss of a tax is large. 23

14. Tax distortions and elasticity
A.S.Akat
EC101 – Chapter 8
Tax distortions and elasticity
Demand
Supply
(c) Inelastic Demand
(d) Elastic Demand
Price
Quantity
Size of
tax
When demand is relatively
elastic, the deadweight
loss of a tax is large.
When demand is
relatively inelastic,
the deadweight
loss of a tax
is small. 24

15. Deadweight loss and tax revenue
A.S.Akat
EC101 – Chapter 8
Deadweight loss and tax revenue
The deadweight loss of a tax rises even more rapidly than the size of the tax
If we double the tax, the size of the triangle increases four times
With each increase in the tax rate, tax revenues will rise slowly, reach a maximum, and then decline
This interesting relation between the tax rate and tax revenue is summarised in the Laffer curve
Increases in tax rates first increase tax revenues but after a certain ceiling tax revenues fall as tax rates continue to increase
Governments must keep the Laffer curve in mind when they set tax rates 31

16. Supply-side economics
A.S.Akat
EC101 – Chapter 8
Supply-side economics
Some economists believe that high taxes discourage people to put more efforts in order to gain a higher income or take bigger risks
Supply-side economics contend that lower tax rates will increase tax revenues due of the higher economic activity resulting from tax cuts
This is in line with the Laffer curve
In the 1980s the Reagan administration in the US put supply-side economics into practice
Tax rates were substantially reduced while government spending remained unchanged
The result was large budget deficits because taxe revenues fell despite the claims of supply-siders 31

17. Deadweight loss and tax revenue
A.S.Akat
EC101 – Chapter 8
Deadweight loss and tax revenue
Small Tax
Price
Supply
Deadweight
loss PB
Tax revenue PS
Demand Q2 Q1
Quantity 31

18. Deadweight loss and tax revenue
A.S.Akat
EC101 – Chapter 8
Deadweight loss and tax revenue
Large Tax
Price PB
Supply
Deadweight
loss
Tax revenue
Demand PS Q2 Q1
Quantity 31

19. Deadweight loss and tax revenue
A.S.Akat
EC101 – Chapter 8
Deadweight loss and tax revenue
Medium Tax
Price
Supply
Deadweight
loss PB
Tax
revenue PS
Demand Q2 Q1
Quantity 31

20. The Laffer curve and supply-side economics
A.S.Akat
EC101 – Chapter 8
The Laffer curve and supply-side economics
(a) Revenue (the Laffer curve)
(b) Deadweight Loss
Tax
Revenue
Deadweight
Loss
Tax Size
Tax Size 8

21. A.S.Akat
EC101 – Chapter 8
Conclusion
A tax on a good reduces consumer and producer surplus by an amount that is greater than the tax revenue generated
The difference between the decrease in total consumer and producer surplus and the tax revenue generated is called the deadweight loss of a tax
The deadweight loss of a tax depends on the price elasticities of demand and supply
As the tax rate becomes bigger, its deadweight loss also grows bigger
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 32