ECONOMIC COSTS OF TAXATION

1
ECONOMIC COSTS OF TAXATION
We have seen that a per unit tax placed on
buyers has exactly the same effect as a per unit
tax levied on sellers. In particular, the
incidence of the tax is on both buyers and
sellers. Buyers pay part of the tax in terms of
the increased price that they pay and sellers pay
part of the tax in terms of the decreased price
that they receive. However, as we shall see, the
real cost of the tax is the lost quantity
available on the market.
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ECONOMIC COSTS OF TAXATION
Since there is no difference between a tax levied
on buyers and a tax levied on sellers, we will
examine the effect on economic welfare of a per
unit tax levied on sellers.
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ECONOMIC COSTS OF TAXATION
Without a tax, P is the equilibrium price and
Q is the equilibrium quantity. The tax shifts
the supply curve up by the amount of the tax.
Buyers now pay price PB and sellers
receive price PS after deducting the tax from PB.
The market
S
TAX REVENUE
TAX
S
PB
TAX WEDGE
P
PS
QT
Q
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ECONOMIC COSTS OF TAXATION
quantity falls to QT so that the tax revenue
(PB-PS)xQT TAX x QT. The tax drives a wedge
between the price paid by buyers and the price
received by sellers. The cost of the tax is the
loss in market quantity from Q to QT.
S
TAX REVENUE
TAX
S
PB
TAX WEDGE
P
PS
QT
Q
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ECONOMIC COSTS OF TAXATION
We can measure the cost of this lost
quantity, using consumer and producer surplus,
which measures the (net) benefits to buyers
and sellers.
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ECONOMIC COSTS OF TAXATION
Suppose the market demand curve is QD 16 -
2p and the market supply curve is QS -4
2p
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ECONOMIC COSTS OF TAXATION
Then without taxes, the market is in
equilibrium when QS QD -4 2p 16 -
2p, which gives an equilibrium quantity of QE6
and an equilibrium price of pE5.
pE5
QE 6
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ECONOMIC COSTS OF TAXATION
Consumer surplus (CS) is the area of triangle
abpE 1/2 x 6 x (8-5)9, and producer surplus
(PS) is the area of triangle pEbc 1/2 x 6 x
(5-2)9. Then the total surplus, when there
is no tax, is CSPS18.
a
CS
pE5
b
PS
c
QE 6
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ECONOMIC COSTS OF TAXATION
With a tax of 1 levied on sellers, the price
sellers receive after paying the tax is the
price buyers pay (p) minus the tax, or p-1.
Then the supply curve with the tax is
QS-42(p-1) and the demand curve
remains QD16-2p.
TAX
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ECONOMIC COSTS OF TAXATION
Equating quantity supplied and quantity
demanded, -4 2(p-1) 16 -2p gives an
equilibrium price paid by buyers of 5.5, and
a price received by sellers of 5.5 minus the tax,
or 4.5. The equilibrium quantity is 5. Then the
governments
TAX
Q5
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ECONOMIC COSTS OF TAXATION
Tax revenue is 1 for each of the 5 units sold or
1 x 5 5. Consumer surplus is the triangular
area below the demand curve and above the price
paid by buyers 1/2 x 5 x (8-5.5)6.25. Producer
surplus is the triangular area above the
TAX REVENUE
TAX
CS
PS
Q5
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ECONOMIC COSTS OF TAXATION
Supply curve and below the price received by
sellers 1/2 x 5 x (4.5-2) 6.25. Therefore,
due to the tax revenue the sum of consumer and
producer surplus has fallen from 18 without a tax
to only 12.5 with a tax.
TAX REVENUE
TAX
CS
PS
Q5
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ECONOMIC COSTS OF TAXATION
Even if the government returns the tax revenue of
5 to buyers and sellers, the total surplus is
only 17.5 with the tax, still less than the total
surplus of 18 without the tax. This is because
the market quantity has fallen from 6
TAX REVENUE
TAX
CS
PS
Q5
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ECONOMIC COSTS OF TAXATION
5. The total surplus with the tax is the area of
the trapezoid abde (17.5), while the total
surplus without the tax is area of the triangle
ace (18). The difference is the area of the
triangle bcd which is 1/2 x 1 x 1 0.5.
a
TAX
b
c
d
e
5
6
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ECONOMIC COSTS OF TAXATION
This is known as a deadweight loss because it is
not recovered by repayment of the tax revenues to
the buyers and sellers. As long as the tax is
levied (even if paid back), buyers value the good
more than sellers. The difference
DEADWEIGHT LOSS
TAX
5
6
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ECONOMIC COSTS OF TAXATION
Is the amount of the tax on each unit sold.
Since buyers value the good more highly than
sellers they would benefit from increased sales,
but the tax wedge removes the incentive for
sellers to sell a larger quantity.
DEADWEIGHT LOSS
TAX
5
6
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ECONOMIC COSTS OF TAXATION
If the tax is doubled to 2, the supply curve is
now QS -4 2(p-2) and the demand curve remains
QD 16 -2p. Equating quantity supplied and
quantity demanded, price paid by buyers is 6,
price received by sellers is 4, and market
quantity is 4. The deadweight loss is 1/2 x tax
wedge x loss of output 1/2 x 2 x 2 2. Then
the deadweight loss is quadrupled when the tax is
doubled.
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ECONOMIC COSTS OF TAXATION
DEADWEIGHT LOSS
The deadweight loss is smaller for the inelastic
demand curve in panel (a) and larger for the
elastic demand
DEADWEIGHT LOSS
TAX
TAX
D
(a) (b)
curve in panel (b). This is because the
deadweight loss depends on the reduction in
quantity, and quantity is more responsive,
ceteris paribus, the more elastic demand.
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ECONOMIC COSTS OF TAXATION
The deadweight loss is smaller in panel (a) where
supply is relatively inelastic, and larger in
panel (b) where supply is
DEADWEIGHT LOSS
DEADWEIGHT LOSS
TAX
TAX
(a)
(b)
relatively elastic. The greater quantity
response to the tax is greater with elastic
supply and so, therefore, is the deadweight loss.
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ECONOMIC COSTS OF TAXATION
The deadweight loss of a per unit tax on a
good will be greater the greater the elasticities
of supply and demand.
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ECONOMIC BENEFITS OF INTERNATIONAL TRADE
When a country engages in international trade,
it those industries with a comparative
advantages should expand production for export --
and those industries with a comparative
disadvantage should contract production.
Therefore owners and workers in the expanding
industries will gain and those in the contracting
industries will lose. Are the gains greater than
the losses? Does society
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ECONOMIC BENEFITS OF INTERNATIONAL TRADE
gain or lose? To answer these questions,
consider a the market for a good in a country not
engaged in international trade.
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ECONOMIC BENEFITS OF INTERNATIONAL TRADE
With no international trade, equilibrium price is
PE and equilibrium quantity is QE. The social
benefit is the sum of consumer surplus
and producer surplus -- triangle abc.
a
CS
b
PS
c
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ECONOMIC BENEFITS OF INTERNATIONAL TRADE
We suppose that there also exists a world market
for this good, and that it is traded in this
market at the world price, PW. Our country is
small relative to the world, so that whether or
not it decides to buy or sell in the world
market will have no effect on the world price.
What if the world price PW is less than the
equilibrium domestic price without trade?
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ECONOMIC BENEFITS OF INTERNATIONAL TRADE
When the country begins international trade, the
domestic price PE falls to the world price PW.
Because the price received by sellers falls,
domestic production falls to QS, and
A
B
D
C
IMPORTS
QD
QS
Because the price paid by buyers falls,
domestic demand rises to QD. The excess demand
is satisfied
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ECONOMIC BENEFITS OF INTERNATIONAL TRADE
by imports.
BEFORE AFTER CHANGE
TRADE TRADE CS A
ABD (BD) PS
BC C -B TOTAL
ABC ABCD D
A
B
D
C
IMPORTS
Pre-trade, consumer surplus
QD
QS
is area A, and post-trade it is area ABD, so
that buyers gain area BD. Pre-trade producer
surplus
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ECONOMIC BENEFITS OF INTERNATIONAL TRADE
BEFORE AFTER CHANGE
TRADE TRADE CS A
ABD (BD) PS
BC C -B TOTAL
ABC ABCD D
A
B
D
C
is area BC, while post-trade it is only area C.
Therefore
IMPORTS
QD
QS
sellers lose a surplus equal to area B. However,
consumers could give sellers part of their
post-trade
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ECONOMIC BENEFITS OF INTERNATIONAL TRADE
BEFORE AFTER CHANGE
TRADE TRADE CS A
ABD (BD) PS
BC C -B TOTAL
ABC ABCD D
A
B
D
C
surplus equal to B and still have a larger
post-trade
IMPORTS
QD
QS
surplus. Therefore it is possible to
compensate sellers so that they are no worse off
after trade, while
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ECONOMIC BENEFITS OF INTERNATIONAL TRADE
BEFORE AFTER CHANGE
TRADE TRADE CS A
ABD (BD) PS
BC C -B TOTAL
ABC ABCD D
A
B
D
C
buyers are better off after trade. This
represents a
IMPORTS
QD
QS
net gain to society, so that trade can improve
the welfare of some members of society, without
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ECONOMIC BENEFITS OF INTERNATIONAL TRADE
decreasing the welfare of any other group, if
the gainers compensate the losers.
Unfortunately the compensation is difficult and
is rarely done, so that trade usually causes
displacements that imposes costs on the resources
in the import competing industry. However, when
a country begins to trade, they will also begin
to export, and resources from the import
competing industry
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ECONOMIC BENEFITS OF INTERNATIONAL TRADE
will find employment in the exporting industry.