Transcript Chapter 8
Chapter 8 The Costs of Taxation Ratna K. Shrestha Overview The Deadweight Loss of Taxation The Determinants of Deadweight Loss The Relation Between Deadweight Loss and Tax Revenue as Taxes Vary How does the application of a tax affect the market system? Market Efficiency The economic well-being of a society is measured as the sum of consumer surplus and producer surplus. Market Efficiency is attained when total surplus is maximized, In a perfectly competitive market, total surplus is maximized at a point where Supply = Demand. Market Efficiency without Taxation P Consumer Surplus S PE Producer Surplus D Q Taxes! Taxes! Taxes! Who pays the tax on a good? The buyer or the seller? How is the burden of a tax divided between buyer and seller? When the government levies a tax on a good, the equilibrium quantity of the good falls. The size of the market for that good shrinks. The Effects of Tax Price It does not matter which side of the market (D or S) the tax is imposed. 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 The Deadweight Loss of Taxation P A tax places a wedge between the price Pb buyers pay and the price sellers receive. It results in a Deadweight Loss, the loss in consumer and Ps producer surplus combined. S Tax! Loss! D Qtax Qno tax Q Deadweight Loss of Taxation When a tax is levied on buyers, the demand curve shifts (vertical shift) downward by the size of the tax. When a tax is levied on sellers, the supply curve shifts upward by that amount. The losses to buyers and sellers exceed the tax revenue raised by the government, leading to a Deadweight Loss. Deadweight Loss of Taxation: Example On the graph (next slide), the current market situation of P = $0.50 per unit of a product results in 1,000 units being offered for sale and purchased. Suppose a twenty cent tax per quantity ($0.20/quantity) is imposed on the suppliers. Sellers “collect” the tax and send the tax revenue to the government. Deadweight Loss of Taxation P Supply $.50 Demand 1000 Q Deadweight Loss of Taxation P Supply A $.60 B $.50 D $.40 C E $.20 tax imposed F Demand 800 1000 Q Deadweight Loss of Taxation: Example The twenty cent tax (per quantity) results in new prices to consumers and producers: – Consumers pay $0.60 – Sellers receive $0.40 (= $0.6 – 0.2) The Tax Revenue from the imposed tax is = $0.2 x 800 = $160. The loss in quantity demanded and the quantity supplied is 200 units (=1000 - 800). Deadweight Loss of Taxation P Tax Revenue Supply $.60 $.50 $.40 Demand 800 1000 Q Changes in Welfare from a Tax See slide #11 Without Tax With Tax Change CS A+B+C A - (B+C) PS D+E+F F - (D+E) Tax Revenue None B+D + (B+D) Total Surplus A+B+C+ D+E+F A+B+D+F - (C+E) Deadweight Loss of Taxation P Supply $.60 $.50 $.40 Loss in Quantity Demand 800 1000 Q Deadweight Loss of Taxation P Supply $.60 Deadweight Loss = $20 $.50 $.40 Demand 800 1000 Q Deadweight Loss of Taxation: Example The value of the loss to society due to the twenty cent tax = $20 (1/2 x0.2x 200). This loss is called deadweight loss. Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade (next graph). Tax results in Q2 amount being sold and purchased. Although, the value of one more unit of Q (beyond Q2) is higher to the consumer than its cost of production (MC), this production is not realized. Why Taxes Cause 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 Deadweight Loss The magnitude of the Deadweight Loss (DWL) depends upon how large a decline in market exchange (decline in Q) occurs as a result of the tax. In the previous example, the decrease in Q = Q1 - Q2 The size in the decline in market exchange depends upon how sensitive consumers and producers are to changes in prices: that is the Elasticity of Supply and Demand. The more elastic demand and supply are, the greater will be the decline in equilibrium quantity and the greater the DWL. More Elastic Demand and Supply S0 PE D0 QE More Elastic Demand and Supply S2 Amount of Tax P2 S0 PE D0 Q2 QE More Elastic Demand and Supply S2 Amount of Tax P2 S0 Deadweight Loss! PE P1 D0 Q2 QE Determinants of Deadweight Loss A tax causes a deadweight loss because it induces buyers and sellers to change their behavior. – Higher prices (P2) cause buyers to buy less. – Lower prices (P1) received causes sellers to offer less. This market distortion (decline in equilibrium Q) caused by taxes increases with the elasticity of supply and demand. Less Elastic Demand and Supply S0 PE D0 QE Less Elastic Demand and Supply S2 P2 S0 Amount of Tax Deadweight Loss! PE P1 D0 Q2 QE Deadweight Loss and Tax Revenue The deadweight loss of a tax rises more rapidly than the tax rate. – If we double the tax rate, the area of the triangle hence deadweight loss increases four times. With each increase in the tax rate, tax revenues will rise slowly, reach a maximum, and then decline (Laffer Curve). In 1974, A. Laffer suggested that the US economy was in the downward sloping portion of the Laffer Curve. Deadweight Loss and Tax Revenue P Deadweight Loss PB PS Supply A small tax causes a small deadweight loss and raises a small revenue Tax Revenue Demand Q2 Q1 Q Deadweight Loss and Tax Revenue P Deadweight Loss PB Supply A larger tax causes a larger deadweight loss and raises a larger revenue Tax Revenue PS Demand Q2 Q1 Q Deadweight Loss and Tax Revenue P Deadweight Loss PB Tax Revenue Supply A very large tax has a very large deadweight loss but may in fact reduce the revenue. PS Demand Q2 Q1 Q Tax Size Vs. Revenue and DWL $ Revenue (Laffer Curve) Deadweight Loss Tax Size Case Study:Deadweight Loss Debate How big should the government be? The larger the deadweight loss of taxation, the larger the cost of any government program. The most important tax on Canadian economy is tax on labor Economists disagree on the size of deadweight loss caused by labor taxation. Those who believe labor tax is highly distorting argue that…… Many workers can adjust the number of hours they work. Higher the net wage, the more overtime hours they choose to work. Case Study:Deadweight Loss Debate Labor tax affects the decision of the second earners (usually married women with children) to work. Many retires decision to work also depends on net wage rate. Higher labor tax encourages jobs that pays “cash under the table.” When two political candidates debate on whether to reduce tax, a part of the disagreement lies on the different views about elasticity of labor supply. Costs of Taxation: Conclusion When a tax is imposed on a good, the tax reduces consumer and producer surplus by an amount that is greater than the tax revenue generated. The difference between the decrease in total consumer and producer surplus and the tax revenue generated is referred to as the Deadweight Loss of a tax. Costs of Taxation: Conclusion As the tax rate gets larger, the deadweight loss increases more proportionately than the tax increase. With the increase in the tax rate, the percentage decrease in market equilibrium quantity becomes greater. As a result, tax revenues begin to decrease after some point.