Chapter 8

Application: The
Costs of Taxation

2002 by Nelson, a division of Thomson Canada Limited

Mankiw et al. Principles of Microeconomics, 2n

In this chapter you will

Examine
Examine how
how taxes
taxes reduce
reduce consumer
consumer and
and
producer
producer surplus.
surplus.
Learn
Learn the
the meaning
meaning and
and causes
causes of
of the
the
deadweight
deadweight loss
loss of
of aa tax.
tax.
Consider
Consider why
why some
some taxes
taxes have
have larger
larger
deadweight
deadweight losses
losses than
than others.
others.
Examine
Examine how
how tax
tax revenue
revenue and
and deadweight
deadweight
loss
loss vary
vary with
with the
the size
size of
of the
the tax.
tax.

APPLICATION: THE COSTS OF

TAXATION
Welfare
Welfare economics
economics is
is the
the study
study of
of
how
how the
the allocation
allocation of
of resources
resources
affects
affects economic
economic well-being.
well-being.
Buyers
Buyers and
and sellers
sellers receive
receive benefits
benefits
from
from taking
taking part
part in
in the
the market.
market.
The
The equilibrium
equilibrium in
in aa market
market
maximizes
maximizes the
the total
total welfare
welfare of
of
buyers
buyers and
and sellers.
sellers.

THE DEADWEIGHT LOSS OF

TAXATION
How
How do
do taxes
taxes affect
affect the
the economic
economic wellwellbeing
being of
of market
market participants?
participants?
ItIt does
does not
not matter
matter whether
whether aa tax
tax on
on aa good
good
is
is levied
levied on
on buyers
buyers or
or sellers
sellers of
of the
the
good
good .. .. .. the
the price
price paid
paid by
by buyers
buyers rises,
rises,
and
and the
the price
price received
received by
by sellers
sellers falls.
falls.

Figure 8-1: The Effects of a Tax

Price

Supply

Size of tax

Price
buyers pay

Price
without tax

Price sellers
receive

Demand

Quantity
with tax

Quantity
without tax

Quantity

How a Tax Affects Market Participants

AAtax
taxplaces
placesaa wedge
wedgebetween
betweenthe
the price
price buyers
buyers
pay
payand
andthe
theprice
pricesellers
sellersreceive.
receive.
Because
Becauseof
ofthis
this tax
taxwedge,
wedge, the
thequantity
quantitysold
sold falls
falls
below
below the
thelevel
levelthat
that would
would be
be sold
soldwithout
withoutaa tax.
tax.
The
Thesize
sizeof
ofthe
themarket
marketfor
for that
thatgood
goodshrinks.
shrinks.
Tax
TaxRevenue
Revenue
TT==the
thesize
sizeof
ofthe
thetax
tax
QQ==the
thequantity
quantityof
ofthe
thegood
goodsold
sold

TT Q
Q ==the
thegovernments
governmentstax
taxrevenue
revenue

Figure 8-2: Tax Revenue

Price

Supply

Size of tax (T)

Price
buyers pay

Tax
Revenue
(T x Q)
Price sellers
receive

Quantity
sold (Q)

Quantity
with tax

Demand

Quantity
without tax

Quantity

Figure 8-3: How a Tax Affects Welfare

Price

Price
buyers
pay

Supply

A
= PB

B
Price
without
tax

= P1

D
Price
sellers =
receive

PS

F
Demand
0

Q1

Q2

Quantity

How a Tax Affects Market Participants

Changes
Changes in
in Welfare
Welfare
A
Adeadweight
deadweight loss
loss is
is the
the fall
fall in
in total
total
surplus
surplus that
that results
results from
from aa market
market
distortion,
distortion, such
such as
as aa tax.
tax.

Table 8-1: Changes in Welfare from a Tax.

How a Tax Affects Market Participants

Changes
Changes in
in Welfare
Welfare
The
The change
change in
in total
total welfare
welfare includes:
includes:
The
The change
change in
in consumer
consumer surplus,
surplus,
The
The change
change in
in producer
producer surplus,
surplus, and
and
The
The change
change in
in tax
tax revenue.
revenue.
The
The losses
losses to
to buyers
buyers and
and sellers
sellers exceed
exceed
the
the revenue
revenue raised
raised by
by the
the government.
government.
This
This fall
fall in
in total
total surplus
surplus is
is called
called the
the
deadweight
loss
deadweight loss.
loss.
loss

Deadweight Losses and the Gains from

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

Figure 8-4: The Deadweight Loss

Price

Supply
Lost gains
from trade

PB
Size of tax

Price without
tax

PS
Cost to
sellers
Value to
buyers

Q2

Demand

Q1
Reduction in tax due to tax

Quantity

THE DETERMINANTS OF THE DEADWEIGHT

LOSS
What
What determines
determines whether
whether the
the deadweight
deadweight
loss
loss from
from aa tax
tax is
is large
large or
or small?
small?
The
The magnitude
magnitude of
of the
the deadweight
deadweight loss
loss
depends
depends on
on how
how much
much the
the quantity
quantity
supplied
supplied and
and quantity
quantity demanded
demanded
respond
respond to
to changes
changes in
in the
the price.
price.
That,
That, in
in turn,
turn, depends
depends on
on the
the price
price
elasticities
elasticities of
of supply
supply and
and demand.
demand.

Figure 8-5: Tax Distortions and Elasticities

Price

(a) Inelastic Supply

(b) Elastic Supply

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

Size of tax

Size of tax

Supply

Supply

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

Demand
Demand
0

Quantity

Figure 8-5: Tax Distortions and Elasticities

Price

(a) Inelastic Demand

Size of tax

(b) Elastic Demand

Supply

Supply

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

Size of tax

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

Demand

Demand

Quantity

THE DETERMINANTS OF THE DEADWEIGHT

LOSS
The
The greater
greater the
the elasticities
elasticities of
of demand
demand and
and
supply:
supply:
the
the larger
larger will
will be
be the
the decline
decline in
in
equilibrium
equilibrium quantity
quantity and,
and,
the
the greater
greater the
the deadweight
deadweight loss
loss of
of aa tax.
tax.

Deadweight Loss and Tax Revenue as Taxes

Vary
With
With each
each increase
increase in
in the
the tax
tax rate,
rate, the
the
deadweight
deadweight loss
loss of
of the
the tax
tax rises
rises even
even
more
more rapidly
rapidly than
than the
the size
size of
of the
the tax.
tax.

Figure 8-6: Deadweight Loss and Tax Revenue from

Three Taxes of Different Sizes
Price

(a) Small Tax

Supply

Deadweight
loss

PB
Tax revenue

PS

Demand
0

Q2

Q1

Quantity

Figure 8-6: Deadweight Loss and Tax Revenue from

Three Taxes of Different Sizes
Price

(b) Medium Tax

Supply

Deadweight
loss

PB

Tax revenue

PS

Demand
0

Q2

Q1

Quantity

Figure 8-6: Deadweight Loss and Tax Revenue from

Three Taxes of Different Sizes
Price

(c) Large Tax

Supply

PB

Tax revenue

Deadweight
loss

PS
Demand
0 Q2

Q1

Quantity

Deadweight Loss and Tax Revenue as Taxes

Vary

For
For the
the small
small tax,
tax, tax
tax revenue
revenue is
is small.
small.
As
As the
the size
size of
of the
the tax
tax rises,
rises, tax
tax revenue
revenue
grows.
grows.
But
But as
as the
the size
size of
of the
the tax
tax continues
continues to
to rise,
rise,
tax
tax revenue
revenue falls
falls because
because the
the higher
higher tax
tax
reduces
reduces the
the size
size of
of the
the market.
market.

Figure 8-7: How Deadweight Loss and Tax revenue

Vary with the Size of the Tax.
Deadweight
Loss

(a) Deadweight Loss

Tax size

Figure 8-7: How Deadweight Loss and Tax revenue

Vary with the Size of the Tax.
Tax
Revenue

(b) Revenue (the Laffer curve)

Tax size

CASE STUDY: The Laffer Curve and Supply

Side Economics
As
As the
the size
size of
of aa tax
tax increases,
increases, its
its
deadweight
deadweight loss
loss quickly
quickly gets
gets larger.
larger.
By
By contrast,
contrast, tax
tax revenue
revenue first
first rises
rises with
with
the
the size
size of
of aa tax,
tax, but
but then,
then, as
as the
the tax
tax gets
gets
larger,
larger, the
the market
market shrinks
shrinks so
so much
much that
that
tax
tax revenue
revenue starts
starts to
to fall.
fall.

Summary
AAtax
taxon
onaagood
goodreduces
reducesthe
thewelfare
welfare of
of buyers
buyers
and
andsellers
sellersof
of the
thegood,
good, and
andthe
thereduction
reduction in
in
consumer
consumerand
andproducer
producer surplus
surplususually
usuallyexceeds
exceeds
the
therevenues
revenuesraised
raisedby
bythe
thegovernment.
government.
The
Thefall
fallin
intotal
total surplusthe
surplusthesum
sumof
ofconsumer
consumer
surplus,
surplus, producer
producer surplus,
surplus, and
andtax
taxrevenue
revenue
is
is
called
calledthe
thedeadweight
deadweightloss
lossof
ofthe
thetax.
tax.
Taxes
Taxeshave
have aadeadweight
deadweight loss
lossbecause
becausethey
they
cause
causebuyers
buyersto
toconsume
consumeless
lessand
andsellers
sellersto
to
produce
produceless.
less.

Summary
This
This change
change in
in behavior
behavior shrinks
shrinks the
the size
size
of
of the
the market
market below
below the
the level
level that
that
maximizes
maximizes total
total surplus.
surplus.
As
As aa tax
tax grows
grows larger,
larger,itit distorts
distorts incentives
incentives
more,
more, and
and its
its deadweight
deadweight loss
loss grows
grows
larger.
larger.
Tax
Tax revenue
revenue first
first rises
rises with
with the
the size
size of
of aa
tax.
tax.
Eventually,
Eventually,however,
however, aa larger
larger tax
tax reduces
reduces
tax
tax revenue
revenue because
because itit reduces
reduces the
the size
size of
of
the
the market.
market.

The End