Excess Burden and Deadweight Loss

Anderson: Efficiency Effects of Taxes and Subsidies

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Introduction• Taxes and subsidies can cause inefficiencies or

correct for inefficiencies in the market.

• In this chapter we learn how to analyze taxes and subsidies for their efficiency effects.

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Excess Burden of Taxes and Subsidies

• Whenever a tax is placed on a good, service, or form of income, people in the economy are burdened.

• Not only do they have to pay the tax, which is the first form of burden, but they also are induced to change their behavior as a result of the tax.

• That change of behavior causes a second form of burden that we call the excess burden of the tax.

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Excess Burden

• The excess burden of a tax refers to the welfare loss caused by imposition of the tax, over and above the revenue the tax generates.

• In this chapter we consider the causes of excess burden and consider ways to minimize the size of excess burdens resulting from taxation.

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Excess Burden With Demand Curves

• The simplest way to show excess burden is with a demand curve,

• Although a special type of demand curve is needed called a compensated demand curve.

• This type of demand curve takes out the income effects of price changes and only shows the substitution effects.

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Figure 10.1: Ordinary and Compensated Demand

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Figure 10.2: Excess Burden of a Tax

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Excess Burden Formula

2)2/1( xxxx txpEB

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Figure 10.3: Excess Burden When Tax Is Doubled

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Marginal Excess Burden

• It is important to consider how the excess burden of a tax changes when there is a change in the tax rate.

• This concept is known as the marginal excess burden (MEB) of a tax.

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Figure 10.4: Marginal Excess Burden of a Tax Increase

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Excess Burden of a Subsidy

• Subsidies also create excess burden.

• The excess burden is the cost of the subsidy in excess of the welfare improvement created by the subsidy.

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Figure 10.5: Excess Burden of a Subsidy

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Adding the Supply Side to the Story• So far, we have assumed that the supply curve is

perfectly elastic (horizontal).

• If we assume that the supply curve is upward sloping, we can generalize the formula for excess burden.

• Assuming that the elasticity of supply is denoted x we can write the generalized excess burden formula as follows:

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Figure 10.6: Excess Burden With Upward Sloping Supply

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Generalized Excess Burden Formula

EB xp tx x x x x ( / ) / ( / / )1 2 1 12

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Generalized Excess Burden Formula [continued]

• Notice that as the elasticity of supply becomes infinite, the generalized formula collapses to the simple formula first presented.

• Also notice that excess burden is directly related to both elasticities.

• The larger the elasticity of demand or supply, the larger the excess burden.

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The Special Cases of Inelastic Demand and Supply

• The generalized excess burden formula also indicates that the smaller the elasticity of demand or supply, the smaller the excess burden of a tax.

• Consider the cases of zero elasticities of demand and supply in Figure 7.

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Figure 10.7: Excess Burden When Demand or Supply is Inelastic

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Determinants of Excess Burden• From the formula for excess burden, we know its

determinants include:

• Elasticities of demand and supply.

• Price of the good (which determines quantity).

• Tax rate applied to the good.