8

Application: The Costs of

Taxation
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
2
Application: The Costs of Taxation
Welfare economics is the study of how the
allocation of resources affects economic
well-being.
We saw in chapter 7 that
Both buyers and sellers benefit from their
buying and selling
The equilibrium outcome in a perfectly
competitive market maximizes the total surplus
of society.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
3
THE DEADWEIGHT LOSS OF
TAXATION
We saw in chapter 6 how taxes
reduce the equilibrium quantity,
increase the price paid by buyers, and
decrease the price received by sellers.
We also saw that
It does not matter whether a tax on a good is
levied on buyers or sellers of the good;
the outcome is the same in either case
But how do taxes affect the economic well-
being of market participants?
Figure 1 The Effects of a Tax
Size of tax
Quantity 0
Buyers Price
Sellers price
Price buyers
pay
Price sellers
receive
Demand
Supply
Price
without tax
Quantity
without tax
Quantity
with tax
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
5
How a Tax Affects Market Participants
A tax places a wedge between the price
buyers pay and the price sellers receive.
Because of this tax wedge, the quantity
sold falls below the level that would be sold
without a tax.
See chapter 6 for details
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
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How a Tax Affects Market Participants
Tax Revenue
T = the size of the tax
Q = the quantity of the good sold
T Q = the governments tax
revenue
Figure 2 Tax Revenue
Tax
revenue
(T Q)
Size of tax (T)
Quantity
sold (Q)
Quantity 0
Price
Demand
Supply
Quantity
without tax
Quantity
with tax
Price buyers
pay
Price sellers
receive
Figure 3 How a Tax Affects Welfare

A
F
B
D
C
E

Quantity 0
Price

Demand
Supply
= PB
Q2
= PS
Price
buyers
pay
Price
sellers
receive
= P1
Q1
Price
without tax
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
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How a Tax Affects Market Participants
The fall in total welfare includes:
The fall in consumer surplus,
The fall in producer surplus, and
The increase in tax revenue.
The losses to buyers and sellers exceed
the revenue raised by the government.
This fall in total surplus is called the
deadweight loss.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
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Deadweight Losses and the Gains
from Trade
Taxes cause deadweight losses because
they prevent buyers and sellers from
realizing some of the gains from trade.
Figure 4 The Deadweight Loss
Cost to
sellers
Value to
buyers
Size of tax
Quantity 0
Price
Demand
Supply Lost gains
from trade
Reduction in quantity due to the tax
Price
without tax
Q
1

PB
Q
2

PS
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
14
DETERMINANTS OF THE
DEADWEIGHT LOSS
What determines whether the deadweight
loss from a tax is large or small?
The magnitude of the deadweight loss
depends on how much the quantity supplied
and quantity demanded respond to changes in
the price.
That, in turn, depends on the price elasticities
of supply and demand.
Figure 5 Tax Distortions and Elasticities
(a) Inelastic Supply
Price
0 Quantity
Demand
Supply
Size of tax
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Figure 5 Tax Distortions and Elasticities
(b) Elastic Supply
Price
0 Quantity
Demand
Supply
Size
of
tax
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Figure 5 Tax Distortions and Elasticities
Demand
Supply
(c) Inelastic Demand
Price
0 Quantity
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Figure 5 Tax Distortions and Elasticities
(d) Elastic Demand
Price
0 Quantity
Size
of
tax
Demand
Supply
When demand is relatively
elastic, the deadweight
loss of a tax is large.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
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DETERMINANTS OF THE
DEADWEIGHT LOSS
The greater the elasticities of demand and
supply:
the larger the decline in equilibrium quantity
and,
the greater the deadweight loss of a tax.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
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DEADWEIGHT LOSS AND TAX
REVENUE AS TAXES VARY
Some economists argue that taxes on labor
income are highly distortinghave high
deadweight lossesbecause they believe that
labor supply is elastic.
Here are some examples of workers who may respond
more to incentives:
Workers who can adjust the number of hours they work
Families with second earners
Elderly who can choose when to retire
Workers in the underground economy (i.e., those engaging in
illegal activity)
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
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DEADWEIGHT LOSS AND TAX
REVENUE AS TAXES VARY
With each increase in the tax rate, the
deadweight loss of the tax rises even more
rapidly than the size of the tax.
Figure 6 Deadweight Loss and Tax Revenue
from Three Taxes of Different Sizes
Copyright 2004 South-Western
Tax revenue
Demand
Supply
Quantity 0
Price
Q
1

(a) Small Tax
Deadweight
loss
P
B

Q
2

P
S

Figure 6 Deadweight Loss and Tax Revenue
from Three Taxes of Different Sizes
Tax revenue
Quantity 0
Price
(b) Medium Tax
Supply
Demand
P
B

Q
2

P
S

Deadweight
loss
When the tax
rate doubles,
the deadweight
loss quadruples
Q
1

Figure 6 Deadweight Loss and Tax Revenue
from Three Taxes of Different Sizes
T
a
x

r
e
v
e
n
u
e

Demand
Supply
Quantity 0
Price
Q
1

(c) Large Tax
P
B

Q
2

P
S

Deadweight
loss
Figure 6 How Deadweight Loss and Tax Revenue Vary
with the Size of a Tax
(d) deadweight loss continually increases
Deadweight
Loss
0 Tax Size
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
26
DEADWEIGHT LOSS AND TAX
REVENUE AS TAXES VARY
As the size of a tax increases, its
deadweight loss quickly gets larger.
By contrast, tax revenue first rises with the
size of a tax, but then, as the tax gets
larger, the market shrinks so much that tax
revenues start to fall.
27
DEADWEIGHT LOSS AND TAX
REVENUE AS TAXES VARY
Tax revenue = tax rate quantity bought
and sold
TR = T Q
T causes Q
Therefore, the effect of T on TR is
ambiguous
T causes TR when the tax rate (T) is low
T causes TR when the tax rate (T) is high
This gives us the Laffer Curve
Figure 6 How Deadweight Loss and Tax Revenue Vary
with the Size of a Tax
(e) Tax revenue first increases, then decreases (the Laffer curve)
Tax
Revenue
0 Tax Size
T
1
Note that it
makes no sense
at all to make
the tax size
bigger than T
1
.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
29
CASE STUDY: The Laffer Curve and
Supply-side Economics
The Laffer curve depicts the relationship
between tax rates and tax revenue.
Supply-side economics refers to the view that
a tax cut
would induce more people to work, and thereby
have the potential to increase tax revenues.
Large tax cuts were adopted during the
Reagan administration
The results do not settle the debate on the
validity of supply-side economics
CASE STUDY: The Laffer Curve
and Supply-side Economics
Between the early 1970s and mid 1990s, the
French tax rate rose to 59 percent from 49
percent, while the U.S. tax rate held at 40
percent
The average French person of working age
logged 24.4 hours a week in the early 1970s,
one hour more than an American. By the mid
1990s, the French workweek had shrunk to
17.5 hours, while the U.S. workweek had
grown to 25.9 hours
Data from research by Edward Prescott
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
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CASE STUDY: The Laffer Curve
and Supply-side Economics
Country Tax Rate Workweek
Italy 64% 16.5 hours
France 59 17.5
Germany 59 19.3
Canada 52 22.8
UK 44 22.9
USA 40 25.9
Japan 37 27.0
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
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Data from research by
Edward Prescott
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
32
The Price of a Civilized Society
This chapter has focused on the negative
effects of taxes on buyers and sellers in a
market
However, without taxes we would not have
a functioning government
As Oliver Wendell Holmes, Jr., Supreme
Court Justice, once said, Taxes are the
price we pay for a civilized society."
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
33
Summary
A tax on a good reduces the welfare of
buyers and sellers of the good, and the
reduction in consumer and producer
surplus usually exceeds the revenues
raised by the government.
The fall in total surplusthe sum of
consumer surplus, producer surplus, and
tax revenue is called the deadweight
loss of the tax.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
34
Summary
Taxes have a deadweight loss because
they cause buyers to consume less and
sellers to produce less.
This change in behavior shrinks the size of
the market below the level that maximizes
total surplus.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
35
Summary
As a tax grows larger, it distorts incentives
more, and its deadweight loss grows larger.
Tax revenue first rises with the size of a
tax.
Eventually, however, a larger tax reduces
tax revenue because it reduces the size of
the market.