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ECONOMICS
SECOND EDITION in MODULES
Paul Krugman | Robin Wells
with Margaret Ray and David Anderson
MODULE 14 (50)
Efficiency and Deadweight Loss
Krugman/Wells
• The meaning and
importance of total surplus
and how it can be used to
illustrate efficiency in
markets
• How taxes affect total
surplus and can create
deadweight loss
3 of 32
Total Surplus
• The total surplus generated in a market is the total net
gain to consumers and producers from trading in the
market. It is the sum of the producer and the consumer
surplus.
• The concepts of consumer surplus and producer surplus
can help us understand why markets are an effective
way to organize economic activity.
4 of 32
Total Surplus
Price of book
S
Consumer
surplus
Equilibrium price $30
E
Producer
surplus
D
0
1,000
Quantity of books
Equilibrium quantity
5 of 32
The Gains from Trade
• The previous graph shows that both consumers and
producers are better off because there is a market in
this good (i.e. there are gains from trade).
• These gains from trade are the reason everyone is
better off participating in a market economy than they
would be if each individual tried to be self-sufficient.
6 of 32
The Efficiency of Markets
• Claim: The maximum possible total surplus is achieved
at market equilibrium.
• The market equilibrium allocates the consumption of
the good among potential consumers and sales of the
good among potential sellers in a way that achieves the
highest possible gain to society.
• Any change from the market equilibrium reduces total
surplus.
7 of 32
The Efficiency of Markets
1. Reallocate consumption among consumers—take the good
away from buyers who would have purchased the good in
the market equilibrium, and give it to potential consumers
who wouldn’t have bought it in equilibrium.
2. Reallocate sales among sellers—take sales away from sellers
who would have sold the good in the market equilibrium,
and instead compel potential sellers who would not have
sold the good in equilibrium to sell it.
3. Change the quantity traded—compel consumers and
producers to transact either more or less than the
equilibrium quantity.
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Reallocating Consumption Lowers
Consumer Surplus
Price of book
Loss in consumer
surplus if the book
is taken from Ana
and given to Bob
S
A
$35
30
E
B
25
D
0
1,000
Quantity of books
9 of 32
Reallocating Sales Lowers
Producer Surplus
Price of book
S
Y
$35
E
30
25
X
Loss in producer surplus
if Yvonne is made to sell
the book instead of
Xavier
D
0
1,000
Quantity of books
10 of 32
Changing the Quantity Lowers
Total Surplus
Price of book
$35
Loss in total surplus
if the transaction
between Ana and
Xavier is prevented
A
25
Y
Loss in total surplus if the
transaction between
Yvonne and Bob is forced
E
30
S
X
B
D
0
1,000
Quantity of books
11 of 32
The Efficiency of Markets
1. It allocates consumption of the good to the potential buyers
who value it the most, as indicated by the fact that they
have the highest willingness to pay.
2. It allocates sales to the potential sellers who most value the
right to sell the good, as indicated by the fact that they have
the lowest cost.
3. It ensures that every consumer who makes a purchase
values the good more than every seller who makes a sale, so
that all transactions are mutually beneficial.
4. It ensures that every potential buyer who doesn’t make a
purchase values the good less than every potential seller
who doesn’t make a sale, so that no mutually beneficial
transactions are missed.
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Equity and Efficiency
• There is often a trade-off between equity and efficiency:
– policies that promote equity often come at the cost of
decreased efficiency.
– policies that promote efficiency often result in decreased
equity.
• This is often the debate about taxation.
– A tax that rises more than in proportion to income is a
progressive tax.
– A tax that rises less than in proportion to income is a
regressive tax.
– A tax that rises in proportion to income is a proportional
tax.
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The Effects of Taxes on Total Surplus
• An excise tax is a tax on sales of a good or service.
• Excise taxes:
– raise the price paid by buyers.
– reduce the price received by sellers.
• Excise taxes also drive a wedge between the two.
– Examples: Excise tax levied on sales of taxi rides and
excise tax levied on purchases of taxi rides.
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The Supply and Demand for Hotel
Rooms in Potterville
Price of hotel room
$140
120
S
100
Equilibrium
price
E
80
B
60
D
40
20
0
5,000
10,000
15,000
Quantity of hotel rooms
Equilibrium
quantity
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An Excise Tax Imposed on
Hotel Owners
Price
$140
120
Supply curve shifts
upward by the
amount of the tax
S
A
S
100
Excise tax = $40
per room
2
1
E
80
60
D
B
40
20
0
5,000
10,000
15,000
Quantity of hotel rooms
16 of 32
An Excise Tax Imposed on
Hotel Guests
Price
$140
120
100
Excise tax =
$40 per room
A
Demand curve shifts
downward by the
amount of the tax
S
E
80
60
D
1
B
40
20
0
D
2
5,000
10,000
15,000
Quantity of hotel rooms
17 of 32
Price Elasticities and Tax Incidence
• The incidence of a tax is a measure of who really pays it.
• Who really bears the tax burden does not depend on
who officially pays the tax.
• The wedge between the demand price and supply price
becomes the government’s “tax revenue.”
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An Excise Tax Paid Mainly
by Consumers
Price of gasoline
(per gallon)
$2.95
Excise tax =
$1 per
gallon
Tax burden falls
mainly on
consumers
When the price elasticity
of demand is low and
the price elasticity of
supply is high, the
burden of an excise tax
falls mainly on
consumers.
S
2.00
1.95
D
0
Quantity of gasoline (gallons)
19 of 32
An Excise Tax Paid Mainly
by Producers
Price of parking space
S
$6.50
6.00
When the price elasticity of
demand is high and the
price elasticity of supply is
low, the burden of an
excise tax falls mainly on
producers.
D
Excise tax =
$5 per
parking space
Tax burden falls
mainly on
producers
1.50
0
Quantity of parking spaces
20 of 32
Price Elasticities and Tax Incidence
• When the price elasticity of demand is higher than the
price elasticity of supply, an excise tax falls mainly on
producers.
• When the price elasticity of supply is higher than the
price elasticity of demand, an excise tax falls mainly on
consumers.
• So elasticity—not who officially pays the tax—determines
the incidence of an excise tax.
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The Revenue from an Excise Tax
Price of hotel room
The tax revenue collected is:
Tax revenue = $40 per room × 5,000 rooms =
$200,000
$140
120
A
S
100
Excise tax = $40 per
room
80
60
D
B
The area of the shaded rectangle is:
Area = Height × Width = $40 per room ×
5,000 rooms = $200,000
40
20
0
E
Area = tax
revenue
6
5,000
10,000
15,000
Quantity of hotel rooms
22 of 32
The Revenue from an Excise Tax
• The general principle: The revenue collected by an
excise tax is equal to the area of the rectangle whose
height is the tax wedge between the supply and demand
curves and whose width is the quantity transacted under
the tax.
23 of 32
The Costs of Taxation
• A fall in the price of a good generates a gain in consumer
surplus.
• Similarly, a price increase causes a loss to consumers.
• So it’s not surprising that, in the case of an excise tax, the
rise in the price paid by consumers causes a loss.
• Meanwhile, the fall in the price received by producers
leads to a fall in producer surplus.
• A tax reduces both, the CS and the PS.
24 of 32
A Tax Reduces Consumer
and Producer Surplus
Price
Fall in consumer surplus
due to tax
P
Excise tax =
T
C
A
P
B
E
E
F
C
P
S
P
Fall in producer surplus
due to tax
Q
T
Q
E
D
Quantity
25 of 32
The Costs of Taxation
• Although consumers and producers are hurt by the tax,
the government gains revenue.
• The revenue the government collects is equal to the tax
per unit sold, T, multiplied by the quantity sold, QT.
• But a portion of the loss to producers and consumers
from the tax is not offset by a gain to the government.
• The deadweight loss caused by the tax represents the
total surplus lost to society because of the tax.
• The deadweight loss is the amount of surplus that would
have been generated by transactions that now do not
take place because of the tax.
26 of 32
The Deadweight Loss of a Tax
Price
S
Deadweight loss
P
Excise tax = T
P
P
C
E
E
P
D
Q
T
Q
E
Quantity
27 of 32
The Deadweight Loss of a Tax
• Using a triangle to measure deadweight loss is a
technique used in many economic applications.
• They are also used to measure the deadweight loss
produced by monopoly, another kind of market
distortion.
• Deadweight-loss triangles are often used to evaluate the
benefits and costs of public policies besides taxation—
such as whether to impose stricter safety standards on a
product.
28 of 32
Cost of Collecting Taxes
• The administrative costs of a tax are the resources used
by government to collect the tax, and by taxpayers to pay
it, over and above the amount of the tax, as well as to
evade it.
• The total inefficiency caused by a tax is the sum of its
deadweight loss and its administrative costs.
• The general rule for economic policy is that, other things
equal, a tax system should be designed to minimize the
total inefficiency it imposes on society.
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1. Total producer surplus in a market, the sum of the
individual producer surpluses in a market, is equal to the
area above the market supply curve but below the price.
2. Total surplus, the total gain to society from the production
and consumption of a good, is the sum of consumer and
producer surplus.
3. Usually, markets are efficient and achieve the maximum
total surplus.
4. Excise taxes — taxes on the purchase or sale of a good—
raise the price paid by consumers and reduce the price
received by producers, driving a wedge between the two.
30 of 32
5. The incidence of the tax—how the burden of the tax is
divided between consumers and producers—does not
depend on who officially pays the tax.
6. The incidence of an excise tax depends on the price
elasticities of supply and demand. If the price elasticity of
demand is higher than the price elasticity of supply, the tax
falls mainly on producers; if the price elasticity of supply is
higher than the price elasticity of demand, the tax falls
mainly on consumers.
7. Excise taxes cause inefficiency in the form of deadweight
loss because they discourage some mutually beneficial
transactions. Taxes also impose administrative costs —
resources used to collect the tax.
31 of 32
8. An excise tax generates revenue for the government, but
lowers total surplus. The loss in total surplus exceeds the tax
revenue, resulting in a deadweight loss to society.
9. An efficient tax minimizes both the sum of the deadweight
loss due to distorted incentives and the administrative costs
of the tax. However, tax fairness, or tax equity, is also a goal
of tax policy.
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