Chapter 8 The Costs of Taxation Ratna K. Shrestha
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Chapter 8
The Costs of Taxation
Ratna K. Shrestha
Overview
The Deadweight Loss of Taxation The Determinants of Deadweight Loss The Relation Between Deadweight Loss and
Tax Revenue as Taxes Vary How does the application of a tax affect the
market system?
Market Efficiency
The economic well-being of a society is measured as the sum of consumer surplus and producer surplus.
Market Efficiency is attained when total surplus is maximized,
In a perfectly competitive market, total surplus is maximized at a point where Supply = Demand.
Market Efficiency without Taxation
S
D
PE
ConsumerSurplus
ProducerSurplus
Q
P
Taxes! Taxes! Taxes!
Who pays the tax on a good? The buyer or the seller?
How is the burden of a tax divided between buyer and seller?
When the government levies a tax on a good, the equilibrium quantity of the good falls.
The size of the market for that good shrinks.
The Effects of Tax
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Taxrevenue (T × Q)
Size of tax (T)
Quantitysold (Q)
Quantity0
Price
Demand
Supply
Quantitywithout tax
Quantitywith tax
Price buyerspay
Price sellersreceive
It does not matter which side of the market (D or S) the tax is imposed.
The Deadweight Loss of Taxation
A tax places a wedge between the price buyers pay and the price sellers receive.
It results in a Deadweight Loss, the loss in consumer and producer surplus combined.
Tax!
P
Q
D
SPb
Ps
Loss!
Qtax Qno tax
Deadweight Loss of Taxation
When a tax is levied on buyers, the demand curve shifts (vertical shift) downward by the size of the tax.
When a tax is levied on sellers, the supply curve shifts upward by that amount.
The losses to buyers and sellers exceed the tax revenue raised by the government, leading to a Deadweight Loss.
Deadweight Loss of Taxation: Example
On the graph (next slide), the current market situation of P = $0.50 per unit of a product results in 1,000 units being offered for sale and purchased.
Suppose a twenty cent tax per quantity ($0.20/quantity) is imposed on the suppliers. Sellers “collect” the tax and send the tax revenue to the government.
Deadweight Loss of Taxation
$.50
1000
Demand
SupplyP
Q
Deadweight Loss of Taxation
$.50
1000
Demand
Supply
$.60
$.40
800
$.20 tax imposed
P
Q
A
B C
D E
F
Deadweight Loss of Taxation: Example
The twenty cent tax (per quantity) results in new prices to consumers and producers:– Consumers pay $0.60– Sellers receive $0.40 (= $0.6 – 0.2)
The Tax Revenue from the imposed tax is = $0.2 x 800 = $160.
The loss in quantity demanded and the quantity supplied is 200 units (=1000 - 800).
Deadweight Loss of Taxation
$.50
1000
Demand
Supply
$.60
$.40
800
Tax RevenueP
Q
Changes in Welfare from a Tax
Without Tax With Tax Change
CS A+B+C A - (B+C)
PS D+E+F F - (D+E)
Tax Revenue None B+D + (B+D)
Total Surplus A+B+C+
D+E+F
A+B+D+F - (C+E)
See slide #11
Deadweight Loss of Taxation
$.50
1000
Demand
Supply
$.60
$.40
800
Loss inQuantity
P
Q
Deadweight Loss of Taxation
$.50
1000
Demand
Supply
$.60
$.40
800
DeadweightLoss = $20
Q
P
Deadweight Loss of Taxation: Example
The value of the loss to society due to the twenty cent tax = $20 (1/2 x0.2x 200). This loss is called deadweight loss.
Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade (next graph).
Tax results in Q2 amount being sold and purchased. Although, the value of one more unit of Q (beyond Q2) is higher to the consumer than its cost of production (MC), this production is not realized.
Why Taxes Cause Deadweight Loss?
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Cost tosellersValue to
buyers
Size of tax
Quantity0
Price
Demand
SupplyLost gainsfrom trade
Reduction in quantity due to the tax
Pricewithout tax
Q1
PB
Q2
PS
Determinants of Deadweight Loss
The magnitude of the Deadweight Loss (DWL) depends upon how large a decline in market exchange (decline in Q) occurs as a result of the tax. In the previous example, the decrease in Q = Q1 - Q2
The size in the decline in market exchange depends upon how sensitive consumers and producers are to changes in prices: that is the Elasticity of Supply and Demand.
The more elastic demand and supply are, the greater will be the decline in equilibrium quantity and the greater the DWL.
More Elastic Demand and Supply
S0
D0
QE
PE
More Elastic Demand and Supply
S0
D0
QE
PE
S2
Amount of Tax
Q2
P2
More Elastic Demand and Supply
S0
D0
QE
PE
S2
Amount of Tax
Q2
P2
DeadweightLoss!
P1
Determinants of Deadweight Loss
A tax causes a deadweight loss because it induces buyers and sellers to change their behavior.– Higher prices (P2) cause buyers to buy
less.– Lower prices (P1) received causes sellers
to offer less. This market distortion (decline in equilibrium
Q) caused by taxes increases with the elasticity of supply and demand.
Less Elastic Demand and Supply
S0
D0
QE
PE
Less Elastic Demand and Supply
S0
D0
QE
PE
S2
P2
Q2
Amount of Tax
DeadweightLoss!
P1
Deadweight Loss and Tax Revenue
The deadweight loss of a tax rises more rapidly than the tax rate. – If we double the tax rate, the area of the
triangle hence deadweight loss increases four times.
With each increase in the tax rate, tax revenues will rise slowly, reach a maximum, and then decline (Laffer Curve).
In 1974, A. Laffer suggested that the US economy was in the downward sloping portion of the Laffer Curve.
Deadweight Loss and Tax Revenue
PS
Q1
Demand
Supply
PB
Q2Q
P
Tax Revenue
Deadweight Loss
A small tax causes a small deadweight loss and raises a small revenue
Deadweight Loss and Tax Revenue
PS
Q1
Demand
Supply
PB
Q2 Q
P
Tax Revenue
Deadweight Loss
A larger tax causes a larger deadweight loss and raises a larger revenue
Deadweight Loss and Tax Revenue
PS
Q1
Demand
SupplyPB
Q2 Q
P
Tax Revenue
Deadweight Loss
A very large tax has a very large deadweight loss but may in fact reduce the revenue.
Tax Size Vs. Revenue and DWL
Tax Size
Deadweight Loss
$
Revenue (Laffer Curve)
Case Study:Deadweight Loss Debate
How big should the government be? The larger the deadweight loss of taxation, the
larger the cost of any government program. The most important tax on Canadian economy is
tax on labor Economists disagree on the size of deadweight
loss caused by labor taxation. Those who believe labor tax is highly distorting argue that……Many workers can adjust the number of hours
they work. Higher the net wage, the more overtime hours they choose to work.
Case Study:Deadweight Loss Debate
Labor tax affects the decision of the second earners (usually married women with children) to work.
Many retires decision to work also depends on net wage rate.
Higher labor tax encourages jobs that pays “cash under the table.”
When two political candidates debate on whether to reduce tax, a part of the disagreement lies on the different views about elasticity of labor supply.
Costs of Taxation: Conclusion
When a tax is imposed on a good, the tax 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 referred to as the Deadweight Loss of a tax.
Costs of Taxation: Conclusion
As the tax rate gets larger, the deadweight loss increases more proportionately than the tax increase.
With the increase in the tax rate, the percentage decrease in market equilibrium quantity becomes greater. As a result, tax revenues begin to decrease after some point.
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