8

Application: The
Costs of Taxation

The Effects 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 is
placed on the buyers or the sellers;
the outcome is the same in either case

But how do taxes affect the economic

well-being of market participants?
2
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

Welfare Economics
Welfare economics is the study of how
the allocation of resources affects
economic well-being.
We saw in Chapter 7 that
Buyers benefit from buying (consumer
surplus), and
Sellers benefit from selling (producer
surplus)
The equilibrium outcome in a perfectly
competitive market maximizes the total
surplus of society.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

Applying welfare economics to

study the effects of taxation
In this chapter we will combine what
we learned in Chapters 6 and 7 to
compare the costs and the benefits
of a tax

4
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

Figure1 The Effects of a Tax

Buyers Price
Sellers price

Supply
Price buyers pay

Size of tax

Price
without tax
Price sellers
receive
Demand

Quantity
with tax

Quantity
without tax

Quantity

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

This fall in output is the cost of the

tax
6
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

How a Tax Affects Market

Participants

Governments earn revenue from taxes

This revenue is the benefit of the tax
Tax Revenue
T = the size of the tax
Q = the quantity of the good sold

T Q = the governments tax

revenue
7
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

Figure 2 Tax Revenue

Price

Supply
Price buyers
pay

Size of tax (T)

Tax
revenue
(T Q)

Price sellers
receive
Demand

Quantity
sold (Q)
0

Quantity
with tax

Quantity
without tax

Quantity

Figure 3 How a Tax Affects

Welfare
Price

Price
buyers=PB
pay

Supply

A
B

Price
=P1
without tax
Price
sellers=PS
receive

D
F

Demand

Q2

Q1

Quantity

Deadweight Losses and the

Gains from Trade
The cost of a tax exceeds the benefit
of a tax
The decrease in total surplus that is
caused by a tax is the deadweight
loss of the tax
Taxes cause deadweight losses
because they prevent buyers and
sellers from realizing some of the
gains from trade.

13

CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

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

Q1

Demand

Quantity

Reduction in quantity due to the tax

DETERMINANTS OF THE
DEADWEIGHT LOSS
What determines whether the
deadweight loss from a tax is large or
small?
The size of the deadweight loss depends
on how much the quantity supplied and
quantity demanded respond to changes
in the price.
In other words, the size of a taxs
deadweight loss depends on the price
elasticities of supply and demand.

15

CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

Figure 5 Tax Distortions and Elasticities

(a) Inelastic Supply
Price
Supply

When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax

Demand
0

Quantity

Figure 5 Tax Distortions and Elasticities

(b) Elastic Supply
Price
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Size
of
tax

Supply

Demand
0

Quantity

Figure 5 Tax Distortions and Elasticities

(c) Inelastic Demand
Price
Supply

Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.

Demand
0

Quantity

Figure 5 Tax Distortions and Elasticities

(d) Elastic Demand
Price
Supply

Size
of
tax

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

Quantity

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.

20
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

The Deadweight Loss Debate

Some economists argue that taxes on labor
income are highly distortingthat is, taxes
on labor income have 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)
21

CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

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.

22
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

Figure 6 Deadweight Loss and Tax

Revenue from Three Taxes of Different
Sizes
(a) Small Tax
Price

Deadweight
loss Supply
PB
Tax revenue
PS
Demand

Q2

Q1 Quantity
Copyright 2004 South-Western

Figure 6 Deadweight Loss and Tax

Revenue from Three Taxes of Different
(b) Medium Tax
Sizes
Price
Deadweight
loss

PB

Supply

Tax revenue

PS

Demand

Q2

Q1 Quantity

When the tax

rate doubles,
the deadweight
loss quadruples

Figure 6 Deadweight Loss and Tax

Revenue from Three Taxes of Different
Sizes
(c) Large Tax
Price
PB

Tax revenue

Deadweight
loss

Supply

Demand
PS
0

Q2

Q1 Quantity

Figure 6 How Deadweight Loss and Tax Revenue

Vary with the Size of a Tax
(d) deadweight loss continually increases
Deadweight
Loss

Tax Size

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 quantity bought
and sold shrinks so much that tax
revenues start to fall.
27
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

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
28

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
Note that it
makes no sense
at all to make the
tax size bigger
than T1.

T1

Tax Size

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 30
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

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

31
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

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

Data from research by

Edward Prescott
32
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

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."

33
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

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.
34
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

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.

35
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

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.
36
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION