Principles of Micro

1. Principles of Micro by Tanya Molodtsova, Fall 2005 Chapter 8: “Application: The Cost of Taxation”

2. We Will Learn: • taxes reduce consumer and producer surplus • the meaning and causes of the deadweight loss from a tax • why some taxes have larger deadweight losses than others • how tax revenue and deadweight loss vary with the size of a tax

3. The Deadweight Loss of Taxation • Buyers and sellers receive benefits from taking part in the market. • The total welfare of buyers and sellers is maximized in equilibrium • How do taxes affect the economic well-being of market participants?

4. 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 buyers rises, and the price received by sellers falls.

5. Price Supply Price buyers Size of tax pay Price without tax Price sellers receive Demand Quantity 0 Quantity Quantity with tax without tax The Effect of a Tax

6. How a Tax Affects Market Participants • A tax places a wedge between the price buyers pay and the price sellers receive. • the quantity sold falls below the level that would be sold without a tax. • The size of the market for that good shrinks

7. How a Tax Affects Market Participants • Tax Revenue • T = the size of the tax • Q = the quantity of the good sold T Q = the government’s tax revenue

8. Price Supply Price buyers Size of tax (T) pay Tax revenue (T × Q) Price sellers receive Demand Quantity sold (Q) Quantity Quantity 0 Quantity with tax without tax Tax Revenue

9. Price Supply A Price buyers PB = pay B C Price P1 = without tax E D Price sellers PS = receive F Demand Quantity 0 Q2 Q1 How a Tax Affects Welfare

10. How a Tax Affects Welfare • Welfare Before a Tax: Consumer surplus = A + B + C. Producer surplus = D + E + F. Total surplus = A+ B+ C+ D+ E+F. • Welfare After Tax: Consumer surplus = A. Producer surplus = F. Tax revenue = B + D. Total surplus = A + B + D + F.

11. How a Tax Affects Welfare • Total surplus decreases by C+E • deadweight loss: the fall in total surplus that results from a market distortion, such as a tax.

12. How a Tax Affects Welfare • 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.

13. 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.

14. Lost gains Supply from trade PB Size of tax Price without tax PS Cost to Demand sellers Value to buyers Quantity 0 Q2 Q1 Reduction in quantity due to the tax The Deadweight Loss

15. The Determinants of the Deadweight Loss • 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.

16. Price Supply When supply is relatively inelastic, the deadweight loss of a tax is small. Size of tax Demand 0 Quantity Tax Distortions and Elasticities (a) Inelastic Supply

17. When supply is relatively elastic, the deadweight loss of a tax is large. Supply Size of tax Demand Tax Distortions and Elasticities (b) Elastic Supply Price Quantity 0

18. Supply Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small. Demand Tax Distortions and Elasticities (c) Inelastic Demand Price Quantity 0

19. Supply Size of tax Demand When demand is relatively elastic, the deadweight loss of a tax is large. Tax Distortions and Elasticities (d) Elastic Demand Price Quantity 0

20. The Determinants of the Deadweight Loss • The greater the elasticities of demand and supply: • the larger will be the decline in quantity sold and, • the greater the deadweight loss of a tax.

21. Case Study: The Deadweight Loss Debate • Some economists argue that labor taxes are highly distorting and believe that labor supply is elastic. • 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)

22. Deadweight Loss and Tax Revenue as Taxes Vary • As taxes increase, the deadweight loss from the tax increases. • In fact, as taxes increase, the deadweight loss rises more quickly than the size of the tax. • The deadweight loss is the area of a triangle. • If we double the size of a tax, the base and height of the triangle both double so the area of the triangle (the deadweight loss) rises by a factor of four.

23. (a) Small Tax Price Deadweight loss Supply PB Tax revenue PS Demand Quantity 0 Q2 Q1 Deadweight Loss and Tax Revenue as Taxes Vary

24. (b) Medium Tax Price Deadweight loss PB Supply Tax revenue PS Demand Quantity 0 Q2 Q1 Deadweight Loss and Tax Revenue as Taxes Vary

25. Price PB Deadweight loss Supply Tax revenue Demand PS Quantity 0 Q2 Q1 Deadweight Loss and Tax Revenue as Taxes Vary (c) Large Tax

26. 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.

27. (a) Deadweight Loss Deadweight Loss Tax Size 0 Deadweight Loss and Tax Revenue as Taxes Vary

28. (b) Revenue (the Laffer curve) Tax Revenue Tax Size 0 Deadweight Loss and Tax Revenue as Taxes Vary

29. 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 revenue starts to fall.

30. 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 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

31. 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.

32. 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.

33. 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.