APPLICATION: THE COSTS OF TAXATION

1
APPLICATIONTHE COSTS OF TAXATION

• Chapter 8

2
The Costs of Taxation

• How do taxes affect the economic well-being of
  market participants?

3
Market Efficiency Three Observations

• Free markets allocate the supply of goods to the
  buyers who value them most highly.

4
Market Efficiency Three Observations

• Free markets allocate the demand for goods to the
  sellers who can produce them at least cost.

5
Market Efficiency Three Observations

• Free markets produce the quantity of goods that
  maximizes the sum of consumer and producer
  surplus.

6
Market Efficiency

• Market efficiency is attained when total surplus
  is maximized, a point where resource allocation
  is efficient.

7
The Costs of Taxation

• 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.

8
The Costs of Taxation
9
The Costs of Taxation

• A tax places a wedge between the price buyers pay
  and the price sellers receive.
• The losses to buyers and sellers exceed the tax
  revenue, leading to a deadweight loss.
• A deadweight loss is a reduction in total surplus
  that results from a tax.

10
Deadweight Loss of Taxation An Example

• At the current price of 0.50 per unit, 1,000
  units are being sold.

11
Deadweight Loss of Taxation An Example
Price
Supply

0.50

Demand
Quantity
0
1000
12
Deadweight Loss of Taxation An Example

• A twenty-cent tax (0.20) is imposed on
  suppliers.
• Suppliers collect the tax and send the tax
  revenue to the government.

13
Deadweight Loss of Taxation An Example

• The twenty-cent tax results in new prices to
  consumers and producers
• ä Consumers pay 0.60.
• ä Sellers receive 0.40.
• The higher price to buyers and the lower price to
  sellers result in a lower quantity sold.

14
Deadweight Loss of Taxation An Example
Price
Supply
0.60

0.50

0.40
Demand
Quantity
0
1000
800
15
Deadweight Loss of Taxation An Example

• Tax Revenue From the Tax
• Tax times quantity sold
• (0.60-0.40) x 800
• 160

16
Deadweight Loss of Taxation An Example
Price
Supply
0.60
B

0.50
D

0.40
Demand
Quantity
0
1000
800
17
Deadweight Loss of Taxation

• Because the tax places a wedge between the price
  buyers pay and the price seller receive, this
  lowers quantity sold by 200 units (1000 - 800).

18
Deadweight Loss of Taxation
19
Deadweight Loss of Taxation An Example
Price
Supply
0.60
0.50
0.40
Demand
Quantity
0
1000
800
20
Deadweight Loss of Taxation An Example

• The loss to society due to the twenty- cent tax
  is the area of a triangle, or 20.

21
Deadweight Loss of Taxation An Example
Price
Supply
0.60

0.50

0.40
F
Demand
Quantity
0
1000
800
22
Deadweight Loss of Taxation

• Taxes cause deadweight losses because they
  prevent buyers and sellers from realizing some of
  the gains from trade.

23
Deadweight Loss of Taxation

• The deadweight loss caused by the decrease in the
  quantity sold is not captured by the government.

24
Quick Quiz!

• Draw a supply and demand curve for cookies.

25
Quick Quiz!

• If the government imposes a tax on cookies, show
  what happens to the quantity sold, the price paid
  by buyers, and the price paid by sellers.

26
Quick Quiz!

• In your diagram, show the deadweight loss from
  the tax.

27
Quick Quiz!

• Explain the meaning of deadweight loss.

28
Determinants of Deadweight Loss

• 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.

29
Determinants of Deadweight Loss

• The more elastic are demand and supply, the
  larger will be the decline in equilibrium
  quantity and the larger the deadweight loss.

30
Tax Distortions and Elasticity
31
Tax Distortions and Elasticity
32
Tax Distortions and Elasticity
33
Determinants of Deadweight Loss

• A tax has a deadweight loss because it induces
  buyers and sellers to change their behavior.
• ä Higher prices cause buyers to buy less.
• ä Lower prices cause sellers to offer less.
• The size of the market shrinks below the optimum.

34
Quick Quiz!

• The demand for beer is more elastic than the
  demand for milk.

35
Quick Quiz!

• Would a tax on beer or a tax on milk have a
  larger deadweight loss?

36
Deadweight Loss and Tax Revenue

• The deadweight loss of a tax rises even more
  rapidly than the size of the tax.
• ä It is the area of a triangle.
• ä If we double the tax, the size of the
  triangle increases four times.

37
Deadweight Loss and Tax Revenue

• With each increase in the tax rate, tax revenues
  will rise slowly, reach a maximum, and then
  decline.

38
Deadweight Loss and Tax Revenue
Small Tax
Price
Supply
Deadweight loss
PB
Tax revenue
PS
Demand
Quantity
Q2
0
Q1
39
Deadweight Loss and Tax Revenue
Medium Tax
Price
Supply
Deadweight loss
PB
Tax revenue
PS
Demand
Quantity
Q2
0
Q1
40
Deadweight Loss and Tax Revenue
Large Tax
Price
Supply
PB
Deadweight loss
Tax revenue
Demand
PS
Quantity
Q2
0
Q1
41
Quick Quiz!

• If the government doubles the tax on gasoline,
  can you be sure that revenue from the gasoline
  tax will rise?

42
Quick Quiz!

• Can you be sure that the deadweight loss from the
  gasoline tax will rise?

43
Conclusion

• A tax on a good reduces consumer and producer
  surplus by an amount that is greater than the tax
  revenue generated.

44
Conclusion

• The difference between the decrease in total
  consumer and producer surplus and the tax revenue
  generated is called the deadweight loss of a tax.

45
Conclusion

• As a tax grows larger, its deadweight loss grows
  larger.

46
Conclusion

• 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.

47
APPLICATIONTHE COSTS OF TAXATION

• End of Chapter 8

48
Figure 8-1
49
Figure 8-2
50
Figure 8-3
51
Price
Supply
Lost gains from trade
P
B
Size of tax
Price without tax
P
S
Cost to sellers
Demand
Value to buyers
Quantity
Q2
0
Q1
Reduction in quantity due to the tax
Figure 8-4
52
Figure 8-5a-b
53
(c) Inelastic Demand
(d) Elastic Demand
Price
Price
Supply
Supply
Size of tax
When demand is relatively inelastic, the
deadweight loss of a tax is small.
Size of tax
Demand
When demand is relatively elastic, the
deadweight loss of a tax is large.
Demand
0
Quantity
0
Quantity
Figure 8-5c-d
54
(a) Small Tax
Price
Supply
Deadweight loss
PB
Tax revenue
PS
Demand
Quantity
Q2
0
Q1
Figure 8-6a
55
(b) Medium Tax
Price
Supply
Deadweight loss
PB
Tax revenue
PS
Demand
Quantity
Q2
0
Q1
Figure 8-6b
56
(c) Large Tax
Price
Supply
PB
Deadweight loss
Tax revenue
Demand
PS
Quantity
Q2
0
Q1
Figure 8-6c
57
(a) Deadweight Loss
Deadweight Loss
0
Tax Size
(b) Revenue (the Laffer curve)
Tax Revenue
0
Tax Size
Figure 8-7