microeconomic
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MiCh8ApplicationTheCostsofTaxation.pptxApplication:
The Costs of Taxation
CHAPTER
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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PowerPoint Slides prepared by:
V. Andreea CHIRITESCU
Eastern Illinois University
N. GREGORY MANKIW PRINCIPLES OF MICROECONOMICS Eight Edition
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Deadweight Loss of Taxation
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
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Deadweight Loss of Taxation
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
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Deadweight Loss of Taxation
Tax burden
Distributed between producers and consumers
Determined by elasticities of supply and demand
Market for the good
Smaller
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Figure 1 The Effects of a Tax
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.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
Quantity
0
Demand
Supply
Price buyers pay
Price without tax
Price sellers receive
Size of tax
Quantity
with tax
Quantity
without tax
Deadweight Loss of Taxation
Economic welfare
Buyers: consumer surplus
Sellers: producer surplus
Government: total tax revenue
Tax times quantity sold
Public benefit from the tax
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
“You know, the idea of taxation with representation doesn’t appeal to me very much, either.”
Figure 2 Tax Revenue
The tax revenue that the government collects equals T × Q, the size of the tax T times the quantity sold Q. Thus, tax revenue equals the area of the rectangle between the supply and demand curves.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
Quantity
0
Demand
Supply
Quantity
without tax
Size of tax (T)
Tax
revenue
T ˣ Q
Price buyers pay
Price sellers receive
Quantity sold (Q)
Quantity
with tax
Figure 3 How a Tax Affects Welfare
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).
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
Quantity
0
A
B
D
F
Q1
C
E
Q2
Supply
Demand
Price
buyers
pay
=PB
Price
sellers
receive
=PS
Price
without
tax
=P1
Deadweight Loss of Taxation
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
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Deadweight Loss of Taxation
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
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Deadweight Loss of Taxation
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
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Figure 4 The Source of a Deadweight Loss
When the government imposes a tax on a good, the quantity sold falls from Q1 to Q2.
At every quantity between Q1 and Q2, the potential gains from trade among buyers and sellers are not realized. These lost gains from trade create the deadweight loss.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
Quantity
0
Demand
Supply
Q1
PS
Price without tax
PB
Q2
Size of tax
Value to
buyers
Cost to
sellers
Lost gains
from trade
Reduction in quantity due to the tax
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
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Figure 5 Tax Distortions and Elasticities (a, b)
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. Notice that the more elastic the supply curve, the larger the deadweight loss of the tax.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
Quantity
0
(a) Inelastic Supply
(b) Elastic Supply
When supply is relatively inelastic, the deadweight loss of a tax is small
Price
Quantity
0
When supply is relatively elastic, the deadweight loss of a tax is large
Demand
Supply
Demand
Supply
Size
of tax
Size
of tax
Figure 5 Tax Distortions and Elasticities (c, d)
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. Notice that the more elastic the demand curve, the larger the deadweight loss of the tax.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
Quantity
0
(c) Inelastic Demand
(d) Elastic Demand
Demand
Supply
When demand is relatively inelastic, the deadweight loss of a tax is small
Price
Quantity
0
Demand
Supply
When demand is relatively elastic, the deadweight loss of a tax is large
Size
of tax
Size
of tax
The deadweight loss debate
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
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
The deadweight loss debate
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)
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
The deadweight loss debate
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
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
“What’s your position on the elasticity of labor supply?”
The deadweight loss debate
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)
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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
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Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (a, b, c)
The deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the amount of the tax multiplied by the amount of the good sold.
In panel (a), a small tax has a small deadweight loss and raises a small amount of revenue.
In panel (b), a somewhat larger tax has a larger deadweight loss and raises a larger amount of revenue.
In 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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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Price
Quantity
0
(a) Small tax
Demand
Supply
Deadweight loss
Q1
PB
PS
Q2
Tax
revenue
Price
Quantity
0
(b) Medium tax
Demand
Supply
Deadweight loss
Q1
PB
PS
Q2
Tax
revenue
Price
Quantity
0
(c) Large tax
Demand
Supply
Deadweight loss
Q1
PB
PS
Q2
Tax revenue
Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (d, e)
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 called the Laffer curve.
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Deadweight loss
Tax size
0
(d) From panel (a) to panel (c),
deadweight loss continually increases
(e) From panel (a) to panel (c), tax
revenue first increases, then decreases
Tax Revenue
Tax size
0
Laffer curve
The Laffer curve and supply-side economics
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
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
The Laffer curve and supply-side economics
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
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
The Laffer curve and supply-side economics
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
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
ASK THE EXPERTS
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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.
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ASK THE EXPERTS
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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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.”
