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Chapter08ApplicationTheCostsofTaxation.pptx

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Principles of Economics, Ninth Edition N. Gregory Mankiw

PowerPoint Slides prepared by:

V. Andreea CHIRITESCU

Eastern Illinois University

N. Gregory Mankiw Principles Of Economics Ninth Edition

Chapter 8

Application: The Costs of Taxation

Deadweight Loss of Taxation, Part 1

Tax on a good levied on buyers

Demand curve shifts downward

By the size of tax

Tax on a good levied on sellers

Supply curve shifts upward

By the size of tax

Deadweight Loss of Taxation, Part 2

Tax on a good levied on buyers or on sellers

Same outcome: a price wedge

Price paid by buyers rises

Price received by sellers falls

Lower quantity sold

Deadweight Loss of Taxation, Part 3

Tax burden

Distributed between producers and consumers

Determined by elasticities of supply and demand

Market for the good

Smaller

Figure 1 The Effects of a Tax

Deadweight Loss of Taxation, Part 4

Economic welfare

Buyers: consumer surplus

Sellers: producer surplus

Government: total tax revenue

Tax times quantity sold

Public benefit from the tax

“You know, the idea of taxation with representation doesn’t appeal to me very much, either.”

Figure 2 Tax Revenue

Figure 3 How a Tax Affects Welfare

Deadweight Loss of Taxation, Part 5

Welfare without a tax

Consumer surplus, areas A, B, and C

Producer surplus, areas D, E, and F

Total tax revenue = 0

Welfare with tax

Smaller consumer surplus, area A

Smaller producer surplus, area F

Total tax revenue, areas B and D

Smaller overall welfare

Deadweight Loss of Taxation, Part 6

Losses of surplus to buyers and sellers, from a tax

Exceed the revenue raised by the government

Deadweight loss

Fall in total surplus that results from a market distortion, such as a tax

Taxes distort incentives

Markets allocate resources inefficiently

Deadweight Loss of Taxation, Part 7

Deadweight losses and gains from trade

Taxes cause deadweight losses

Prevent buyers and sellers from realizing some of the gains from trade

The gains from trade

Difference between buyers’ value and sellers’ cost are less than the tax

Once the tax is imposed some trades are not made: deadweight loss

Figure 4 The Source of a Deadweight Loss

Determinants of Deadweight Loss

Price elasticities of supply and demand

More elastic supply curve

Larger deadweight loss

More elastic demand curve

Larger deadweight loss

The greater the elasticities of supply and demand

The greater the deadweight loss of a tax

Figure 5 Tax Distortions and Elasticities (a, b)

Figure 5 Tax Distortions and Elasticities (c, d)

The Deadweight Loss Debate, Part 1

How big should the government be?

The larger the deadweight loss of taxation

The larger the cost of any government program

If taxes impose large deadweight losses

These losses are a strong argument for a leaner government that does less and taxes less

If taxes impose small deadweight losses

Government programs are less costly

The Deadweight Loss Debate, Part 2

How big are the deadweight losses of taxation?

Economists disagree

Tax on labor (the labor tax)

Social Security tax, Medicare tax, much of federal income tax

Places a wedge between the wage that firms pay and the wage that workers receive

Marginal tax rate on labor income is 40% (tax rate on the last dollar of earnings)

The Deadweight Loss Debate, Part 3

40% labor tax: Small or large deadweight loss?

Some believe labor supply

is fairly inelastic

Almost vertical

Most people would work full-time regardless of wage

Tax on labor: small deadweight loss

“What’s your position on the elasticity of labor supply?”

The Deadweight Loss Debate, Part 4

Others: labor supply is more elastic

Tax on labor: greater deadweight loss

Many workers can adjust the number of hours they work (overtime)

Some families have second earners; some discretion over whether to do unpaid work at home or paid work in the marketplace

Many of the elderly can choose when to retire

Some people consider engaging in illegal economic activity (underground economy)

Deadweight Loss & Tax Revenue

As the tax increases

Deadweight loss increases

Even more rapidly than the size of the tax

Tax revenue

Increases initially

Then decreases

The higher tax: drastically reduces the size of the market

Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (a, b, c)

Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (d, e)

The Laffer Curve and Supply-Side Economics, Part 1

1974, economist Arthur Laffer

Laffer curve

Supply-side economics

Tax rates were so high that reducing them would actually raise tax revenue

Ronald Reagan’s experience in film industry

High tax rates caused less work

Low tax rates caused more work

The Laffer Curve and Supply-Side Economics, Part 2

Ronald Reagan ran for president in 1980

Platform: cutting taxes

Argument

Taxes were so high that they were discouraging hard work

Lower taxes would give people the proper incentive to work

Raise economic well-being

Perhaps increase tax revenue

The Laffer Curve and Supply-Side Economics, Part 3

Economists

Continue to debate Laffer’s argument

No consensus about the size of the relevant elasticities

General lesson:

Change in tax revenue from a tax change depends on how the tax change affects people’s behavior

ASK THE EXPERTS, Part 1

The Laffer Curve

“A cut in federal income tax rates in the United States right now would lead to higher national income within five years than without the tax cut.”

Source: IGM Economic Experts Panel, June 26, 2012.

ASK THE EXPERTS, Part 2

The Laffer Curve

“A cut in federal income tax rates in the United States right now would raise taxable income enough so that the annual total tax revenue would be higher within five years than without the tax cut.”