1. LECTURE #7: MICROECONOMICS CHAPTER 8
Economic Costs of Taxation
Deadweight Loss and Social Policy

2. The Deadweight Loss of Taxation
Taxes (Sales, Use or Excise)
Levied on buyers
Demand curve shifts downward by the size of tax
Levied on sellers
Supply curve shifts upward by the size of tax
Same outcome: price wedge
Price paid by buyers – rises
Price received by sellers – falls
Lower quantity sold 2

3. The Effects of a Tax 3 Price Demand Price buyers pay Supply Quantity
with tax
Size
of tax
Price without tax
Quantity
without tax
Price sellers receive
Quantity
Figure 1: A tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls. 3

4. The Deadweight Loss of Taxation
Tax Burden
Distributed between producers and consumers
Determined by elasticities of S & D
Market for the good – smaller
Taxes and Deadweight Losses
Welfare losses to buyers and sellers exceed tax revenues to government
Deadweight Loss = fall in total surplus
Taxes prevent buyers and seller from realizing gains from trade 4

5. Economic Costs of Taxation
Tax Revenue = Amount of tax (T) times Quantity (Q) (See Fig 2)
Recall: Taxes raise the price paid and reduce the prices received.
Taxes effectively reduce consumption.
Reduced consumption = reduced standard of living
Reduced consumption leads to increased in unemployment
Some proportion of the producer/consumer surpluses discussed in Chapter 7 effectively expropriated via taxes. Compare Figure 7, Ch 7 and Figure 3, Ch 8

6. Tax Revenue 6 Price Demand Supply Price buyers pay Quantity with tax
Size of tax (T)
Supply
Price buyers pay
Quantity
with tax
Tax
revenue
T ˣ Q
Quantity
without tax
Price sellers receive
Quantity sold (Q)
Quantity
Figure 2: The tax revenue that the government collects equals T × Q, the size of the tax T times the quantity sold Q. 6

7. Taxes and Deadweight Losses Figure 3
Price
Demand
A tax on a good reduces consumer surplus (by the area B + C) and producer surplus (by the area D + E). Because the fall in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a deadweight loss (area C + E).
Price
buyers
pay
=PB
Supply A Q2 C B
Price
without
tax
=P1 E Q1 D
Price
sellers
receive
=PS F
Quantity
The area C + E shows the deadweight loss resulting from the tax
Without Tax
With Tax
Change
Consumer Surplus
Producer Surplus
Tax Revenue
Total Surplus
A+B+C
D+E+F
None
A+B+C+D+E+F A F
B+D
A+B+D+F
-(B+C)
-(D+E)
+(B+D)
-(C+E) 7

8. Determinants of the Deadweight Loss
Price Elasticities of Supply and Demand
If PED or SED more elastic – deadweight losses are larger
If either is inelastic, deadweight losses are smaller

9. Tax Distortions and Elasticities of Supply
(a) Inelastic supply
(b) Elastic supply
When supply is relatively inelastic, the deadweight loss of a tax is small
Price
Price
When supply is relatively elastic, the deadweight loss of a tax is large
Demand
Supply
Demand
Supply
Size
of tax
Size
of tax
Quantity
Quantity
Figure 5: In panels (a) and (b), the demand curve and the size of the tax are the same, but the price elasticity of supply is different. The more elastic the supply curve, the larger the deadweight loss of the tax. 9

10. Tax Distortions and Elasticities of Demand
(c) Inelastic demand
(d) Elastic demand
When demand is relatively inelastic, the deadweight loss of a tax is small
When demand is relatively elastic, the deadweight loss of a tax is large
Price
Price
Supply
Supply
Demand
Demand
Size
of tax
Size
of tax
Quantity
Quantity
Figure 5: In panels (c) and (d), the supply curve and the size of the tax are the same, but the price elasticity of demand is different. The more elastic the demand curve, the larger the deadweight loss of the tax. 10

11. Break Time

12. Deadweight Loss and Social Policy
The larger the deadweight loss, the more expensive social programs
The greater the elasticity of supply and demand, the greater the deadweight loss
The Economic Argument: The impact of labor taxes
If the labor supply is relatively inelastic – then the deadweight losses are smaller.
If the labor supply is relatively elastic – then the deadweight losses are larger.
Regardless: the larger the tax, the greater the deadweight losses (See Fig 6)

13. Deadweight Loss and Social Policy
Arguments for Elastic Labor Supply
Over-time premiums
Second or third income net take-home pay
Incentives for part time work
Incentives to work "under the table"
Laffer Curve and Supply-Side Economics
Reducing taxes eventually causes revenues to rise
High tax rates discourage working, consumption, and investing
Lowering tax rates encouraged consumption and employment

14. Deadweight Loss, Magnitude of Tax and Tax Revenue Figure 6
(a) Small tax
(b) Medium tax
(c) Large tax
Price
Price
Price
Deadweight
loss
Deadweight
loss
Deadweight
loss
Demand
Demand PB
Demand
Supply
Supply Q2
Supply PB Q2 PB
Tax
revenue Q2
Tax
revenue Q1 Q1
Tax revenue Q1 PS PS PS
Quantity
Quantity
Quantity
Panel (a), a small tax has a small deadweight loss and raises a small amount of revenue.
Panel (b), a larger tax has a larger deadweight loss and raises a larger amount of revenue.
Panel (c), a very large tax has a very large deadweight loss, but because it has reduced the size of the market so much, the tax raises only a small amount of revenue. 14

15. Deadweight Loss, Magnitude of Tax and Tax Revenue
(d) From panel (a) to panel (c),
deadweight loss continually increases
(e) From panel (a) to panel (c), tax
revenue first increases, then decreases
Deadweight
loss
Tax
Revenue
Laffer curve
Tax size
Tax size
Panels (d) and (e) summarize these conclusions. Panel (d) shows that as the size of a tax grows larger, the deadweight loss grows larger. Panel (e) shows that tax revenue first rises and then falls. This relationship is sometimes called the Laffer curve. 15

16. Reagan Revolution Supply Side Economics (Arthur Laffer) Reaganomics
High marginal tax rates discourage working
High marginal tax rates discourage investment
Result is decrease in tax revenues → deficits
Reaganomics
Reduce Marginal Tax Rates
Encourage working
Encourage investment
Increase in incomes → increase in tax revenues
Empirical data suggests the greater the marginal rate, the less people work (See “In The News”, page 170)

17. In The News: On The Way to France WSJ, Oct 20,2003
Country
Tax Rate (%)
Workweek Hrs
Italy 64
16.5
France 59
17.5
Germany
19.3
Canada 52
22.8 UK 44
22.9 US 40
25.9
Japan 37
27.0

18. Homework Questions for Review: 1, 2, 4
Problems and Applications: 6, 12 (a, b, c, e)

19. Problems & Applications
#12. Suppose that a market is described by the following supply and demand equations:
QS = 2P
QD = 300 – P
Solve for the Equilibrium Price and Quantity
Recall that at Equilibrium QS = QD, therefore
2P = 300 – P
3P = 300
P = $100 → QS = 200 and QD = 200 (units)

20. Problem #12 Continued
b. Suppose that a tax of T is placed on buyers. The new demand equation is:
QD = 300 – (P + T)
What is the new Equilibrium?
QS = 2P
2P = 300 – (P + T)
P = 100 – T/3 (price received by seller)
P = T/3 + T = T/3 (price paid by buyer)

21. Problem #12 Continued b.1. Suppose Tax = $15
Producer Receives (PT) = $100 – 5 = $95
Quantity Supplied = 2 (95) = 190
Consumer Pays = P + T = $95 + $15 = $110
New QD = 300 – (S + T) = 300 – 110 = 190
New QS = 2S = 2 * 95 = 190
c. Deadweight Loss = T * Q = $15 * 190 = $2,850
Revenue ϵ = 200 * 100 = 20,000
New Producer Revenue = 190 * 95 = $18,050
New Consumer Expenditure = 110 * 190 = 20,900
Difference = $20,900 – 18,050 = $2,850 (QED)

22. Problem #12 Continued