Download LECTURE #7: MICROECONOMICS CHAPTER 8

LECTURE #7: MICROECONOMICS
CHAPTER 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 sellers
Supply curve shifts upward by the size of tax
Same outcome: price wedge
Price paid by buyers – rises
Price received by sellers – falls
Lower quantity sold
2
The Effects of a Tax
Price
Supply
Price buyers pay
Size
of tax
Price without tax
Price sellers receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
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.
3
The Deadweight Loss of Taxation
Tax Burden
Distributed between producers and consumers
Determined by elasticities of S & D
Market for the good – smaller
Taxes and Deadweight Losses
Welfare 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
Price
Size of tax (T)
Supply
Price buyers pay
Tax
revenue
TˣQ
Price sellers receive
Demand
Quantity
sold (Q)
0
Quantity
with tax
Quantity
without tax
Quantity
Figure 2: The tax revenue that the government collects equals T × Q, the size of the tax
T times the quantity sold Q.
6
Taxes and Deadweight Losses
Figure 3
Price
Price
buyers
pay =PB
Supply
A
B
Price
without =P1
tax
C
E
D
Price =PS
sellers
receive
A 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).
F
Demand
0
Consumer Surplus
Producer Surplus
Tax Revenue
Total Surplus
Q2
Q1
Quantity
Without Tax
With Tax
Change
A+B+C
D+E+F
None
A+B+C+D+E+F
A
F
B+D
A+B+D+F
-(B+C)
-(D+E)
+(B+D)
-(C+E)
The area C + E shows
the deadweight loss
resulting from the tax
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Determinants of the Deadweight Loss
Price Elasticities of Supply and Demand
If PED or SED more elastic – deadweight losses are
larger
If either is inelastic, deadweight losses are smaller
Tax Distortions and Elasticities of Supply
(a) Inelastic supply
When supply is
relatively inelastic,
the deadweight loss
of a tax is small
Price
(b) Elastic supply
Price
When supply is
relatively elastic, the
deadweight loss of
a tax is large
Supply
Supply
Size
of tax
Size
of tax
Demand
0
Quantity
Demand
0
Quantity
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.
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Tax Distortions and Elasticities of Demand
(c) Inelastic demand
When demand is relatively
inelastic, the deadweight
loss of a tax is small
Price
(d) Elastic demand
When demand is relatively
elastic, the deadweight
loss of a tax is large
Price
Supply
Size
of tax
Supply
Size
of tax
Demand
Demand
0
Quantity
0
Quantity
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.
10
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 taxes
If 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 Supply
Over-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 Economics
Reducing 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
(b) Medium tax
(a) Small tax
Price
Price
Deadweight
loss
Deadweight
loss
Supply
Supply
PB
PB
Tax
revenue
Tax
revenue
PS
Deadweight
loss
Demand
Demand P
S
Supply
Tax revenue
Price
PB
(c) Large tax
Demand
PS
0
Q2 Q1
Quantity
0
Q2
Quantity
Q1
0 Q2
Q1
Quantity
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.
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Deadweight Loss, Magnitude of Tax and Tax Revenue
(d) From panel (a) to panel (c),
deadweight loss continually increases
Deadweight
loss
(e) From panel (a) to panel (c), tax
revenue first increases, then decreases
Tax
Revenue
Laffer curve
0
Tax size
0
Tax size
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.
15
Reagan Revolution
Supply Side Economics (Arthur Laffer)
High marginal tax rates discourage working
High marginal tax rates discourage investment
Result is decrease in tax revenues → deficits
Reaganomics
Reduce Marginal Tax Rates
Encourage working
Encourage investment
Increase 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 France
WSJ, 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 Quantity
Recall 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 = $15
Producer 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 = $2,850
Revenue [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