Lecture Principles of economics - Chapter 8: Application: The costs of taxation

In this chapter you will examine how taxes reduce consumer and producer surplus, learn the meaning and causes of the deadweight loss of a tax, consider why some taxes have larger deadweight losses than others, examine how tax revenue and deadweight loss vary with the size of a tax.

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Application: The Costs of Taxation

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THE DEADWEIGHT LOSS OF

TAXATION

• How do taxes affect the economic wellbeing of market participants?

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THE DEADWEIGHT LOSS OF

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Figure 1 The Effects of a Tax

with tax

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How a Tax Affects Market Participants

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• Tax Revenue

• T = the size of the tax

• Q = the quantity of the good sold

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Figure 2 Tax Revenue

Tax revenue

Quantity without tax

Quantity with tax

Price buyers

pay

Price sellers

receive

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Figure 3 How a Tax Effects Welfare

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• Changes in Welfare

• A deadweight loss is the fall in total surplus that

results from a market distortion, such as a tax.

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How a Tax Affects Welfare

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• This fall in total surplus is called the deadweight

loss.

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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

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Figure 4 The Deadweight Loss

Cost to sellers Value to

buyers Size of tax

Reduction in quantity due to the tax

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Figure 5 Tax Distortions and Elasticities

of a tax is small.

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(b) Elastic Supply Price

Demand

Supply Size

of tax

When supply is relatively elastic, the deadweight loss of a tax is large.

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Demand

Supply

(c) Inelastic Demand Price

Size of tax

When demand is relatively inelastic, the deadweight loss

of a tax is small.

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(d) Elastic Demand Price

Size of

Supply

When demand is relatively elastic, the deadweight loss of a tax is large.

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DEADWEIGHT LOSS AND TAX

REVENUE AS TAXES VARY

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• With each increase in the tax rate, the

deadweight loss of the tax rises even more

rapidly than the size of the tax

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

Tax revenue

Demand Supply

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• For the small tax, tax revenue is small

• As the size of the tax rises, tax revenue grows

• But as the size of the tax continues to rise, tax

revenue falls because the higher tax reduces the size of the market

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Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax

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Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax

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CASE STUDY: The Laffer Curve and

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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 surplus—the sum of consumer

surplus, producer surplus, and tax revenue — is called the deadweight loss of the tax

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