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Chapter 8 Application: The Costs of Taxation

Chapter 8 Application: The Costs of Taxation. Review of Taxes. Taxes raise revenue for gov’t & it comes out of someone’s pocket Both buyers & sellers are worse off when a good is taxed Need to compare the reduced welfare of buyers and sellers to the amount of revenue the government raises.

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Chapter 8 Application: The Costs of Taxation

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  1. Chapter 8Application: The Costs of Taxation

  2. Review of Taxes • Taxes raise revenue for gov’t & it comes out of someone’s pocket • Both buyers & sellers are worse off when a good is taxed • Need to compare the reduced welfare of buyers and sellers to the amount of revenue the government raises

  3. Deadweight Loss of Taxation • Welfare without a Tax • Entire area in red & blue is total surplus • Welfare is maximized

  4. Changes in Welfare with a Tax • The losses to buyers and sellers from a tax exceed the revenue raised by the government • This fall in total surplus is called Deadweight Loss • Taxes distort incentives & cause markets to allocate resources inefficiently

  5. Deadweight Loss • Taxes cause DWL because they prevent buyers & sellers from realizing some of the gains from trade

  6. Determinants of Deadweight Loss • Greater elasticities yield greater DWL

  7. DWL and Tax Revenue as Taxes Vary • As tax gets larger, DWL quickly increases • As tax gets larger, tax revenue first rises then starts to fall eventually • Extreme case shown in Laffer Curve

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