allocation of resources affects economic wellbeing. Buyers y and sellers receive benefits from takingg part p in the market. The equilibrium in a market maximizes the total welfare of buyers and sellers.
TAXATION How do taxes affect the economic well-being of market participants?
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THE DEADWEIGHT LOSS OF
TAXATION It does not matter whether a tax on a good is levied on buyers or sellers of the good . . . the price paid by p y buyers y rises, and the price received by sellers falls.
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Figure 1 The Effects of a Tax
How a Tax Affects Market Participants
Price
Supply Price buyers pay
Size of tax
Price without tax Price sellers receive
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. The size of the market for that good shrinks.
Demand
Quantity with tax
Quantity without tax
Quantity Copyright 2004 South-Western
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06.09.2011
Figure 2 Tax Revenue
How a Tax Affects Market Participants
Price
Tax Revenue T = the size of the tax Q = the quantity of the good sold
Supply Price buyers pay
Size of tax (T)
Tax revenue (T Q)
T Q = the governments tax revenue
Price sellers receive
Demand
Quantity sold (Q) 0
Quantity with tax
Quantity
Quantity without tax
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Copyright 2004 South-Western
Figure 3 How a Tax Effects Welfare
How a Tax Affects Market Participants
Price
Price buyers = PB pay
Changes in Welfare A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax.
Supply
A B C
Price without tax = P1 Price sellers = PS receive
D F
Demand
Q2
Q1
Quantity
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Copyright 2004 South-Western
How a Tax Affects Welfare
How a Tax Affects Market Participants
The change in total welfare includes:
The change in consumer surplus,
The change in producer surplus, and The change 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.
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Copyright 2004 South-Western/Thomson Learning
06.09.2011
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
Price
Lost gains from trade
PB
Supply
Size of tax Price without tax PS Cost to sellers
Value to buyers 0
Q2
Demand
Quantity
Q1 Reduction in quantity due to the tax
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DETERMINANTS OF THE DEADWEIGHT LOSS What determines whether the deadweight loss from a tax is large or small?
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Figure 5 Tax Distortions and Elasticities
(a) Inelastic Supply Price Supply
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.
When supply is relatively inelastic, inelastic the deadweight loss of a tax is small. Size of tax
Demand 0
Quantity
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Figure 5 Tax Distortions and Elasticities
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Figure 5 Tax Distortions and Elasticities
(b) Elastic Supply
(c) Inelastic Demand
Price
Price When supply is relatively elastic, the deadweight loss of a tax is large. Size of tax
Supply
Supply Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small.
Demand 0
Demand
Quantity
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Quantity Copyright 2004 South-Western
06.09.2011
Figure 5 Tax Distortions and Elasticities
DETERMINANTS OF THE DEADWEIGHT LOSS
(d) Elastic Demand
The greater the elasticities of demand and
supply:
Price Supply
the larger will be the decline in equilibrium
quantity and, the greater the deadweight loss of a tax. Size of tax
Demand When demand is relatively elastic, the deadweight loss of a tax is large. Quantity
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Copyright 2004 South-Western
DEADWEIGHT LOSS AND TAX
REVENUE AS TAXES VARY The Deadweight Loss Debate Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic. Some examples of workers who may respond more to incentives:
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.
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) Copyright 2004 South-Western/Thomson Learning
Figure 6 Deadweight Loss and Tax Revenue from Three
Taxes of Different Sizes
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Figure 6 Deadweight Loss and Tax Revenue from Three
Taxes of Different Sizes (b) Medium Tax
(a) Small Tax
Price
Price
Deadweight loss Supply
Deadweight loss
PB
Supply
PB Tax revenue
Tax revenue PS
Q2
Demand
PS
Q1 Quantity
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Demand
Q2
Q1 Quantity Copyright 2004 South-Western
06.09.2011
Figure 6 Deadweight Loss and Tax Revenue from Three
Taxes of Different Sizes (c) Large Tax Price PB
Tax revenue
Deadweight loss Supply
DEADWEIGHT LOSS AND TAX
REVENUE AS TAXES VARY 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.
CASE STUDY: The Laffer Curve and Supplyside Economics
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 revenue starts to fall.
The Laffer curve depicts the relationship
between tax rates and tax revenue. Supply-side economics refers to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues.
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Copyright 2004 South-Western/Thomson Learning
06.09.2011
Summary
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 byy the ggovernment. The fall in total surplusthe sum of consumer surplus, producer surplus, and tax revenue is called the deadweight loss of the tax.
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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.
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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, Eventually however however, a larger tax reduces tax revenue because it reduces the size of the market.
