Measures of Excess Burden

• Equivalent variation used in last section• Other measures also available

• Compensating variation:• If real income prior to tax is used as reference point,

the estimate of the change in welfare effect of a tax will alter

• What is the maximum sum that would compensate an individual when there is a tax so as to return the individual to the welfare level prior to tax

• How much should come from outside the system to compensate the tax distortion

• Figure 7-3• The area of CS loss, is greater as it is based on

larger real income• Income effects based on EV or CV differ from

estimates of Marshallian uncompensated demand curve

• CV for price decrease is EV for price increase and EV for price decrease is CV for price increase

The welfare costs of taxation

• General equilibrium analysis:• Selective excise tax is more distortive than an

equal yield income tax• So IT is superior to an excise tax??• GE framework may resolve the issues raised

• GE analysis of resource allocation cost of taxation• Objective of this analysis: Will selective excise

tax create greater resource allocation costs (DWL) than an equal yield IT??

• Figure 7.5• Economy produces 2 goods, X and Y• PPF of 2 goods• X-efficient economy, where should it be placed?

• Producing on the frontier, and pareto optimality the best output level for two goods is at point 1

• MRTxy=MRSxy

• Slope of PPF= slope of CIC• Perfectly competitive market, no market

failures, or externalities; 1 is the scenario best for economy pre-tax