The Effects of Taxation

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The Effects of Taxation
2
Objective of Todays Lecture

• To analyse the impact of taxation on both
  consumers and producers using supply and demand
  analysis
• Key issue Who pays for the tax? Is it the
  consumer or the producer?
• The concept of deadweight loss the society as a
  whole ends up losing more than what it gets in
  return

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What do we already know about taxes? if
anything!

• Fundamental insight of the Laffer curve tax
  rates and tax revenues are not necessarily
  positively related.
• If a tax is severe enough, it can completely
  eliminate trade in the taxed market.
• Taxes can also be levied to curb vices
• If the activity is generating harm and reducing
  that activity generates positive benefits to the
  community, a tax could help in reducing that
  activity

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Types of taxes

• direct taxes (e.g. income taxes, taxes on
  property)
• indirect taxes (e.g. taxes on the expenditure on
  goods and services)
• An expenditure tax is a tax on the sale of a
  particular commodity
• Specific sales tax
• ? As a fixed amount in pence per unit sold
• Ad valorem tax
• ? As a fixed percentage of the value of the
  commodity

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Figure 7.1 The butter market and the effects of
taxation
Price per pound (in pence)
S
136
120 116
D
Quantity per day (pounds of butter)
13.2
14
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Figure 7.1 The butter market and the effects of
taxation
Price per pound (pence)
S
Tax revenue tax rate per pounds of butter
sold 0.20 x 13.2 mill 2.64 million
A
120 116
B
D
Quantity per day (millions of pounds)
13.2
14
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Figure 7.2a Who pays most with a sales tax?
Price per unit
A
B
D
S tax
S
Quantity per day
8
Figure 7.2b Who pays most with a sales tax?
Price per unit
S tax
A
S
B
D
Quantity per day
9
Difference between the two cases

• .. Supply elasticities.
• In figure 7.2a the elasticity of supply is
  lower than in 7.2b (i.e. The responsiveness of
  production to the product price is greater in
  7.2b than in 7.2a).
• General rule the more elastic the supply
  curve, the greater the consumers burden of
  taxation, and vice versa.

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Figure 7.3a The burden of taxation and demand
elasticities
Price per unit
S tax
S
A
Demand is highly inelastic therefore consumer is
more likely to pay more of the tax
B
D
Quantity per day
11
Figure 7.3b The burden of taxation and demand
elasticities
Price per unit
S tax
S
Demand is elastic therefore producer is more
likely to pay more of the tax
A
B
D
Quantity per day
12
Figure 7.3c Elasticities and total tax revenue
Price per unit
S tax
Tax revenue is higher the more inelastic is demand
S
D
Quantity per day
Tax revenue is lower the more elastic is demand
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The excess burden of taxation

• Many taxes generate dead-weight losses
• These are the losses in producer and consumer
  surplus that the governments cannot appropriate
  as tax revenue
• JB Say on taxation Shortly after the
  government passed a tax on doors and windows, my
  landlord had two bricklayers come to my room to
  wall in one of my two windows. As they worked, I
  realised that the mere imposition of the tax had
  now left me with one less window and the
  government with no additional revenue.

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Key Assumption for Our Analysis

• The government collects tax revenue and returns
  it to the society in the form of a transfer

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Figure 7.3a The burden of taxation and demand
elasticities
Price per unit
S tax
S
A
E
F
B
D
Quantity per day
16
Figure 7.3b The burden of taxation and demand
elasticities
Price per unit
S tax
S
E
A
F
B
D
Quantity per day
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Figure 7.4aTax and perfectly inelastic demand
(elasticity 0)
Price per unit
D
S tax
A tax revenue, paid entirely by consumers
Producer bears none of the tax burden No dead
weight
S
A
Quantity per day
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Figure 7.4aTax and perfectly elastic demand
(elasticity ?)
Price per unit
S tax
Tax leads to reduction in quantity demanded, no
price adjustment B tax revenue, paid entirely
by producers Consumer bears none of the tax
burden C dead-weight loss
S
D
C
B
Quantity per day
19
To Sum up

• Governments levy taxes to
• Collect revenue
• Induce agents to behave in certain way
• Tax revenue doesnt grow proportionately with the
  tax rate
• Consumers burden of the tax will be larger the
  more inelastic the demand curve is, ceteris
  paribus
• Producers burden of the tax will be larger, the
  more inelastic the supply curve is, ceteris
  paribus
• The excess burden of taxation is the decrease in
  the welfare of the society brought about by the
  tax