Download Unit 3 _ ppt 2 _ The Costs of Taxation

Happy Tuesday 
• Take out your homework and
please write the number of any
question(s) that you would to go
over in class. Then, put your
homework in the bin.
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Application: The
Costs of Taxation
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8
By the end of this chapter you
should understand…
• How taxes reduce consumer and producer
surplus
• The meaning and causes of the deadweight loss
from a tax
• Why some taxes have larger deadweight losses
than others
• How tax revenue and deadweight loss vary with
the size of a tax
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Today’s LEQ
• How do taxes affect the economic well-being of
market participants?
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Impact of Taxes
• Taxes reduce welfare of buyers & sellers
• Doesn’t matter who’s taxed – buyers pay more and
sellers receive less.
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Figure 1 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
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Impact of Taxes
• Now we have three participants in the market:
buyers, sellers, and the government
• T = the size of the tax
• Q = the quantity of the good sold
T  Q = the government’s tax revenue
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Figure 2 Tax Revenue
Price
Supply
Price buyers
pay
Size of tax (T)
Tax
revenue
(T × Q)
Price sellers
receive
Demand
Quantity
sold (Q)
0
Quantity
with tax
Quantity
without tax
Quantity
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Figure 3 How a Tax Effects Welfare
Price
Price
buyers = PB
pay
Supply
A
B
C
Price
without tax = P1
Price
sellers = PS
receive
E
D
F
Demand
0
Q2
Q1
Quantity
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Impact of Taxes
• With a tax, total surplus now = CS +
PS + Tax Revenue
• Market shrinks (buyers consume less,
sellers produce less) and total surplus
declines
• This is called a deadweight loss: the fall
in total surplus that results from a market
distortion, such as a tax.
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How a Tax Affects Welfare
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Why Does This Happen?
• Tax causes some buyers and sellers to
drop out of the market
• Tax increases price buyers have to pay (some
previous buyers no longer willing to pay)
• Tax decreases price sellers receive (no longer
covers some sellers’ opportunity costs; no
point in selling)
Copyright © 2004 South-Western/Thomson Learning
Figure 4 The Deadweight Loss
Price
Lost gains
from trade
PB
Supply
Size of tax
Price
without tax
PS
Cost to
sellers
Value to
buyers
0
Q2
Demand
Quantity
Q1
Reduction in quantity due to the tax
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“DVD Scene Selection” Summary
• Congratulations! You have been hired by the Wynn
Production Company to create the DVD scene
selection index for the production company’s latest
masterpiece, “Deadweight Loss .” The plot of the
movie can be found in the subsection, “Deadweight
Losses & the Gains from Trade”
• After reading, sketch four panels depicting key scenes
in the sequence of events. Be sure to include a caption
for each panel that captures key ideas and vocabulary.
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QUICK QUIZ #1
• Draw the supply and demand curves for
cookies. If the government imposes a tax on
cookies, show what happens to price paid by
buyers, the price received by sellers, and the
quantity sold. In your diagram, show the
deadweight loss from the tax. Explain the
meaning of deadweight loss.
Copyright © 2004 South-Western/Thomson Learning
DETERMINANTS OF
DEADWEIGHT LOSS
• What determines whether the deadweight loss
from a tax is large or small? ELASTICITY!
• The greater the elasticities of demand and
supply:
• the larger will be the decline in equilibrium
quantity and,
• the greater the deadweight loss of a tax.
Copyright © 2004 South-Western/Thomson Learning
Figure 5 Tax Distortions and Elasticities
(a) Inelastic Supply
Price
Supply
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax
Demand
0
Quantity
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Figure 5 Tax Distortions and Elasticities
(b) Elastic Supply
Price
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Size
of
tax
Supply
Demand
0
Quantity
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Figure 5 Tax Distortions and Elasticities
(c) Inelastic Demand
Price
Supply
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Demand
0
Quantity
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Figure 5 Tax Distortions and Elasticities
(d) Elastic Demand
Price
Supply
Size
of
tax
Demand
When demand is relatively
elastic, the deadweight
loss of a tax is large.
0
Quantity
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QUICK QUIZ #2
• The demand for beer is more elastic than the
demand for milk. Would a tax on beer or at ax
on milk have a larger deadweight loss?
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QUICK QUIZ #3
• Suppose both supply and demand in a market
are relatively inelastic. Will a tax placed on the
product in this market generate a relatively
large or small deadweight loss? Why? Provide
a graph to support your explanation.
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DEADWEIGHT LOSS AND TAX
REVENUE AS TAXES VARY
• The Deadweight Loss Debate
• Some economists argue that labor taxes are highly
distorting and believe that labor supply is more
elastic.
• Some examples of workers who may respond more
to incentives:
•
•
•
•
Workers who can adjust the number of hours they work
Families with second earners
Elderly who can choose when to retire
Workers in the underground economy (i.e., those
engaging in illegal activity)
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DEADWEIGHT LOSS AND TAX
REVENUE AS TAXES VARY
• With each increase in the tax rate, the
deadweight loss of the tax rises even more
rapidly than the size of the tax.
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Figure 6 Deadweight Loss and Tax Revenue from Three
Taxes of Different Sizes
(a) Small Tax
Price
Deadweight
loss Supply
PB
Tax revenue
PS
Demand
0
Q2
Q1 Quantity
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Figure 6 Deadweight Loss and Tax Revenue from Three
Taxes of Different Sizes
(b) Medium Tax
Price
Deadweight
loss
PB
Supply
Tax revenue
PS
0
Demand
Q2
Q1 Quantity
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Figure 6 Deadweight Loss and Tax Revenue from Three
Taxes of Different Sizes
(c) Large Tax
Price
PB
Tax revenue
Deadweight
loss
Supply
Demand
PS
0
Q2
Q1 Quantity
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DEADWEIGHT LOSS AND TAX
REVENUE AS TAXES VARY
• For the small tax, tax revenue is small.
• As the size of the tax rises, tax revenue grows.
• But as the size of the tax continues to rise, tax
revenue falls because the higher tax reduces the
size of the market.
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Figure 7 How Deadweight Loss and Tax Revenue Vary
with the Size of a Tax
(a) Deadweight Loss
Deadweight
Loss
0
Tax Size
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Figure 7 How Deadweight Loss and Tax Revenue Vary
with the Size of a Tax
(b) Revenue (the Laffer curve)
Tax
Revenue
0
Tax Size
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DEADWEIGHT LOSS AND TAX
REVENUE AS TAXES VARY
• As the size of a tax increases, its deadweight
loss quickly gets larger.
• By contrast, tax revenue first rises with the size
of a tax, but then, as the tax gets larger, the
market shrinks so much that tax revenue starts
to fall.
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CASE STUDY: The Laffer Curve and Supplyside Economics
• The Laffer curve depicts the relationship
between tax rates and tax revenue.
• Supply-side economics refers to the views of
Reagan and Laffer who proposed that a tax cut
would induce more people to work and thereby
have the potential to increase tax revenues.
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Summary
• A tax on a good reduces the welfare of buyers
and sellers of the good, and the reduction in
consumer and producer surplus usually exceeds
the revenues raised by the government.
• The fall in total surplus—the sum of consumer
surplus, producer surplus, and tax revenue — is
called the deadweight loss of the tax.
Copyright © 2004 South-Western/Thomson Learning
Summary
• Taxes have a deadweight loss because they
cause buyers to consume less and sellers to
produce less.
• This change in behavior shrinks the size of the
market below the level that maximizes total
surplus.
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Summary
• As a tax grows larger, it distorts incentives
more, and its deadweight loss grows larger.
• Tax revenue first rises with the size of a tax.
• Eventually, however, a larger tax reduces tax
revenue because it reduces the size of the
market.
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