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Application: The Costs of Taxation Copyright © 2006 Nelson, a division of Thomson Canada Ltd. 8 Learning Objectives ● Examine how taxes reduce consumer and producer surplus ● Learn the meaning and causes of the deadweight loss of a tax ● Consider why some taxes have larger deadweight losses than others ● Examine how tax revenue and deadweight loss vary with the size of a tax Copyright © 2006 Nelson, a division of Thomson Canada Ltd. The Costs of Taxation ● Welfare economics is the study of how the allocation of resources affects economic wellbeing. Buyers and sellers receive benefits from taking part in the market. The equilibrium in a market maximizes the total welfare of buyers and sellers. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. THE DEADWEIGHT LOSS OF TAXATION ● How do taxes affect the economic well-being of market participants? ● It does not matter whether a tax on a good is levied on buyers or sellers of the good . . . the price paid by buyers rises, and the price received by sellers falls. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. THE DEADWEIGHT LOSS OF TAXATION ● A tax places a wedge between the price buyers pay and the price sellers receive. ● Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax. ● The size of the market for that good shrinks. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. 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 Copyright © 2004 South-Western How a Tax Affects Market Participants ● The Government: Tax Revenue T = the size of the tax Q = the quantity of the good sold T Q = the government’s tax revenue Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Figure 2 Calculating 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 Copyright © 2004 South-Western How a Tax Affects Market Participants ● Consumers and Producers: Changes in Welfare A tax on a good reduces consumer surplus and producer surplus. Because the fall in consumer and producer surplus exceeds tax revenue, the tax is said to impose a deadweight loss. A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Consumer and Producer Surplus before the Tax Price Supply Price without = P1 tax Total Consumer Surplus Consumer and Producer Producer Surplus Surplus Demand 0 Q1 Quantity Figure 3 How a Tax Affects 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 Copyright © 2004 South-Western How a Tax Affects Welfare Copyright © 2006 Nelson, a division of Thomson Canada Ltd. How a Tax Affects Market Participants ● The change in total welfare includes: decrease in consumer surplus, decrease in producer surplus, and increase in tax revenue. losses to buyers and sellers exceed the revenue raised by the government. This fall in total surplus is called the deadweight loss. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Deadweight Losses and the Gains from Trade ● Producer and Consumer Surplus are gains from trade ● The gains from trade are lost because fewer trades will be made with the tax ● Deadweight loss is the surplus (gains from trade) lost because the tax discourages mutually advantageous Copyright © 2006 Nelson, a division of Thomson Canada Ltd. 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 Copyright © 2004 South-Western DETERMINANTS OF THE DEADWEIGHT LOSS ● What determines the size of the deadweight loss from a tax? depends on how much the quantity supplied and quantity demanded respond to changes in the price. which in turn, depends on the price elasticities of supply and demand. ● The following examples show what happens to deadweight loss when the size of the tax remains the same and the demand curve is the same but supply elasticity changes supply curve is the same but demand elasticity changes Copyright © 2006 Nelson, a division of Thomson Canada Ltd. 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 Copyright © 2006Copyright Nelson, a of Thomson Canada Ltd. © division 2004 South-Western 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 Copyright © 2004 South-Western 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 Copyright © 2004 South-Western 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 Copyright © 2004 South-Western DETERMINANTS OF THE DEADWEIGHT LOSS ● The greater the elasticities of demand and supply: the larger the decline in equilibrium quantity and, the greater the deadweight loss of a tax. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Deadweight Loss Debate ● Some economists believe that labor supply is more elastic, which makes taxes more distorting. ● 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) Copyright © 2006 Nelson, a division of Thomson Canada Ltd. 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. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. 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 Copyright © 2004 South-Western 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 Copyright © 2004 South-Western 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 Copyright © 2004 South-Western 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. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Figure 7 How Deadweight Loss Varies with Tax Size (a) Deadweight Loss Deadweight Loss 0 Tax Size Copyright © 2004 South-Western Figure 7: How Tax Revenue Varies with Tax Size (b) Revenue (the Laffer curve) Tax Revenue 0 Tax Size Copyright © 2004 South-Western 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. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. CASE STUDY: The Laffer Curve and Supply-side 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. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Summary ● A tax on a good reduces the welfare of buyers and sellers of the good, 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 © 2006 Nelson, a division of Thomson Canada Ltd. 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. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. 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 but eventually falls because the size of the market shrinks. Copyright © 2006 Nelson, a division of Thomson Canada Ltd.