lecture #7: microeconomics chapter 8 economic costs of taxation deadweight loss and social policy
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LECTURE #7: MICROECONOMICSCHAPTER 8
Economic Costs of Taxation
Deadweight Loss and Social Policy
The Deadweight Loss of Taxation
Taxes (Sales, Use or Excise)Levied on buyers
Demand curve shifts downward by the size of tax
Levied on sellersSupply curve shifts upward by the size of tax
Same outcome: price wedgePrice paid by buyers – rises
Price received by sellers – falls
Lower quantity sold
2
The Effects of a Tax
3
Price
Quantity0
Demand
SupplyPrice buyers pay
Price without tax
Price sellers receive
Sizeof tax
Figure 1: A tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls.
Quantitywith tax
Quantitywithout tax
The Deadweight Loss of Taxation
Tax BurdenDistributed between producers and consumers
Determined by elasticities of S & D Market for the good – smaller
Taxes and Deadweight LossesWelfare losses to buyers and sellers exceed tax
revenues to government
Deadweight Loss = fall in total surplus
Taxes prevent buyers and seller from realizing gains from trade
4
Economic Costs of Taxation
Tax Revenue = Amount of tax (T) times Quantity (Q) (See Fig 2)Recall: Taxes raise the price paid and reduce the prices
received.
Taxes effectively reduce consumption.Reduced consumption = reduced standard of living
Reduced consumption leads to increased in unemployment
Some proportion of the producer/consumer surpluses discussed in Chapter 7 effectively expropriated via taxes. Compare Figure 7, Ch 7 and Figure 3, Ch 8
Tax Revenue
6
Price
Quantity0
Demand
Supply
Figure 2: The tax revenue that the government collects equals T × Q, the size of the tax T times the quantity sold Q.
Quantitywith tax
Quantitywithout tax
Size of tax (T)
Quantity sold (Q)
Taxrevenue
T ˣ Q
Price buyers pay
Price sellers receive
Taxes and Deadweight LossesFigure 3
7
Price
Quantity0
Demand
SupplyA tax on a good reduces consumer surplus (by the area B + C) and producer surplus (by the area D + E). Because the fall in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a deadweight loss (area C + E).
A
B
D
F
Q1
C
E
Pricesellersreceive
=PS
Pricewithout
tax
=P1
Pricebuyers
pay =PB
Q2
Without Tax With Tax Change
Consumer SurplusProducer SurplusTax RevenueTotal Surplus
A+B+CD+E+FNone
A+B+C+D+E+F
AF
B+DA+B+D+F
-(B+C)-(D+E)+(B+D)-(C+E)
The area C + E shows the deadweight loss resulting from the tax
Determinants of the Deadweight Loss
Price Elasticities of Supply and DemandIf PED or SED more elastic – deadweight losses are
larger
If either is inelastic, deadweight losses are smaller
Tax Distortions and Elasticities of Supply
9
Price
Quantity0
(a) Inelastic supply
Figure 5: In panels (a) and (b), the demand curve and the size of the tax are the same, but the price elasticity of supply is different. The more elastic the supply curve, the larger the deadweight loss of the tax.
(b) Elastic supply
Sizeof tax
When supply is relatively inelastic, the deadweight loss of a tax is small
Price
Quantity0
Sizeof tax
When supply is relatively elastic, the deadweight loss of a tax is large
Demand
Supply
Demand
Supply
Tax Distortions and Elasticities of Demand
10
Price
Quantity0
(c) Inelastic demand
Figure 5: In panels (c) and (d), the supply curve and the size of the tax are the same, but the price elasticity of demand is different. The more elastic the demand curve, the larger the deadweight loss of the tax.
(d) Elastic demand
Sizeof tax
Demand
Supply
When demand is relatively inelastic, the deadweight loss of a tax is small
Price
Quantity0
Sizeof tax
Demand
Supply
When demand is relatively elastic, the deadweight loss of a tax is large
Break Time
Deadweight Loss and Social Policy
The larger the deadweight loss, the more expensive social programs
The greater the elasticity of supply and demand, the greater the deadweight loss
The Economic Argument: The impact of labor taxesIf the labor supply is relatively inelastic – then the
deadweight losses are smaller.If the labor supply is relatively elastic – then the deadweight
losses are larger.Regardless: the larger the tax, the greater the deadweight
losses (See Fig 6)
Deadweight Loss and Social Policy
Arguments for Elastic Labor SupplyOver-time premiums
Second or third income net take-home pay
Incentives for part time work
Incentives to work "under the table"
Laffer Curve and Supply-Side EconomicsReducing taxes eventually causes revenues to rise
High tax rates discourage working, consumption, and investing
Lowering tax rates encouraged consumption and employment
Deadweight Loss, Magnitude of Tax and Tax Revenue
Figure 6
14
Price
Quantity
0
(a) Small tax
Panel (a), a small tax has a small deadweight loss and raises a small amount of revenue.Panel (b), a larger tax has a larger deadweight loss and raises a larger amount of revenue. Panel (c), a very large tax has a very large deadweight loss, but because it has reduced the size of the market so much, the tax raises only a small amount of revenue.
Demand
Supply
Deadweightloss
Q1
PB
PS
Q2
Taxrevenue
Price
Quantity
0
(b) Medium tax
Demand
Supply
Deadweightloss
Q1
PB
PS
Q2
Taxrevenue
Price
Quantity
0
(c) Large tax
Demand
Supply
Deadweightloss
Q1
PB
PS
Q2
Tax
rev
enue
Deadweight Loss, Magnitude of Tax and Tax Revenue
15
Deadweightloss
Tax size0
(d) From panel (a) to panel (c),deadweight loss continually increases
Panels (d) and (e) summarize these conclusions. Panel (d) shows that as the size of a tax grows larger, the deadweight loss grows larger. Panel (e) shows that tax revenue first rises and then falls. This relationship is sometimes called the Laffer curve.
(e) From panel (a) to panel (c), taxrevenue first increases, then decreases
TaxRevenue
Tax size0
Laffer curve
Reagan Revolution
Supply Side Economics (Arthur Laffer)High marginal tax rates discourage workingHigh marginal tax rates discourage investmentResult is decrease in tax revenues → deficits
ReaganomicsReduce Marginal Tax Rates
Encourage workingEncourage investmentIncrease in incomes → increase in tax revenues
Empirical data suggests the greater the marginal rate, the less people work (See “In The News”, page 170)
In The News: On The Way to FranceWSJ, Oct 20,2003
Country Tax Rate (%) Workweek Hrs
Italy 64 16.5
France 59 17.5
Germany 59 19.3
Canada 52 22.8
UK 44 22.9
US 40 25.9
Japan 37 27.0
Homework
Questions for Review: 1, 2, 4
Problems and Applications: 6, 12 (a, b, c, e)
Problems & Applications
#12. Suppose that a market is described by the following supply and demand equations:
QS = 2P
QD = 300 – P
a. Solve for the Equilibrium Price and QuantityRecall that at Equilibrium QS = QD, therefore
2P = 300 – P
3P = 300
P = $100 → QS = 200 and QD = 200 (units)
Problem #12 Continued
b. Suppose that a tax of T is placed on buyers. The new demand equation is:
QD = 300 – (P + T)
What is the new Equilibrium?
QS = 2P
2P = 300 – (P + T)
P = 100 – T/3 (price received by seller)
P = 100 - T/3 + T = 100 + 2T/3 (price paid by buyer)
Problem #12 Continued
b.1. Suppose Tax = $15Producer Receives (PT) = $100 – 5 = $95
Quantity Supplied = 2 (95) = 190
Consumer Pays = P + T = $95 + $15 = $110
New QD = 300 – (S + T) = 300 – 110 = 190
New QS = 2S = 2 * 95 = 190
c. Deadweight Loss = T * Q = $15 * 190 = $2,850Revenue [Expense] @ ϵ = 200 * 100 = 20,000
New Producer Revenue = 190 * 95 = $18,050
New Consumer Expenditure = 110 * 190 = 20,900
Difference = $20,900 – 18,050 = $2,850 (QED)
Problem #12 Continued