Transcript Tax Incidence and Deadweight Loss

Tax Incidence and
Deadweight Loss
Excise Taxes
• Tax charged on each unit of a good or service
that is sold
• Most common tax
– Gasoline, cigarettes
– Local governments impose excise taxes on
services (hotel room rentals)
Excise Tax
• Renting a room in Potterville
• Without taxes,
– equilibrium price of a room $80
– Equilibrium quantity of hotel rooms rented is 10,000
• Now, government imposes an excise tax of $40
per night
– Means – every time a room is rented for the night,
the owner of the hotel must pay the city $40
• What does this imply about the supply curve?
The Supply and Demand for Hotel Rooms
in Potterville
Price of hotel
room
$140
120
S
100
Equilibrium
price
E
80
B
60
D
40
20
0
5,000
10,000
Equilibrium
quantity
15,000
Quantity of hotel
rooms
Excise Tax
• Graph shows that the post-tax supply curve
shifts up by the amount of the tax compared
to the pre-tax supply curve
• At every quantity supplied, the supply price
has increased by $40
An Excise
Tax Imposed on Hotel Owners
Price
$140
120
S
2
Supply curve shifts
upward by the
amount of the tax
A
S
1
100
E
Excise tax = $40
per room
80
60
D
B
40
20
0
5,000
10,000
15,000
Quantity of
hotel rooms
Excise Tax
• The graph also shows the results of a quota
placed on sales
• A quota drives a wedge between the price
paid by consumers and the price received by
producers
• Excise taxes does the same thing
• Excise tax on hotel rooms is actually a tax on
the producers (hotel owners) not the guest
Excise Tax
• What happens if the city levied a tax on
consumers instead of producers?
– Hotel guests pay $40 for each night stayed
An Excise Tax Imposed on Hotel Guests
Price
$140
120
A
100
Excise tax =
$40 per room
Demand curve
shifts downward
by the amount
of the tax
S
E
80
60
D
1
B
40
20
0
D
2
5,000
10,000
15,000
Quantity of
hotel rooms
Both graphs show the same price effect
Consumers pay an effective price of $100, producers receive an effective price of
$60, and 5,000 hotel rooms are bought and sold
**It doesn’t matter who officially pays the tax – the equilibrium outcome is the
same
Tax Incidence
• Incidence of a tax is a measure of who really
pays it
• Who really bears the burden of the tax?
• In reality, between consumers and producers,
one group bears more of a burden than the
other
Excise Tax Paid by Consumers
• What determines how the burden of an
excise tax is allocated between consumers
and producers?
• Depends on the shape of the supply and
demand curve
– Depends on the price elasticity of supply and the
price elasticity of demand
An Excise Tax Paid Mainly By Consumers
Price of gasoline (per gallon)
$2.95
Excise tax =
$1 per
gallon
Tax burden falls
mainly on
consumers
When the price
elasticity of demand is
low and the price
elasticity of supply is
high, the burden of an
excise tax falls mainly
on consumers.
S
2.00
1.95
D
0
Quantity of gasoline (gallons)
Excise Tax Paid by Consumers
• Two key assumptions:
• Price elasticity of demand for gasoline is
assumed to be very low, so the demand curve is
relatively steep
• Price elasticity of supply of gasoline is assumed
to be very high, so the supply curve is relatively
flat
• **When the price elasticity of demand is low
and the price of elasticity of supply is high, the
burden of an excise tax falls mainly on
consumers **
Excise Tax Paid by Consumers
• **When the price elasticity of demand is low
and the price of elasticity of supply is high,
the burden of an excise tax falls mainly on
consumers **
• WHY?
• A low price elasticity of demand means that
consumers have few substitutes and so little
alternatives to buying higher-priced gasoline
An Excise Tax Paid Mainly by Producers
Price of parking space
S
$6.50
6.00
D
Excise tax = $5
per parking
space
Tax burden falls
mainly on
producers
1.50
0
When the
price
elasticity of
demand is
high and the
price
elasticity of
supply is
low, the
burden of
an excise tax
falls mainly
on
producers.
Quantity of parking spaces
Excise Tax on Consumers & Producers
• When the price elasticity of demand is higher
than the price elasticity of supply, an excise
tax falls mainly on producers. When the
price elasticity of supply is higher than the
price elasticity of demand, an excise tax falls
mainly on consumers
• Elasticity (not who pays the tax) determines
the incidence of an excise tax
Benefits and Costs of Taxation
• If government is consider whether to impose
a tax or how to design a tax system, it must
weigh the benefits of a tax against its loses
• Benefit of a tax is the revenue it raises for the
government to pay for these services
• Although, comes at a cost – cost is normally
larger than the amount consumers and
producers pay
Revenue from an Excise Tax
• How much revenue foes the
government collect from an excise
tax?
• In example of hotel
rooms……amount is equal to the
area of the shaded rectangle
The Revenue from an Excise Tax
Price of hotel
room
The tax revenue collected is:
Tax revenue = $40 per room × 5,000 rooms =
$200,000
$140
120
A
S
100
Excise tax = $40
per room
80
60
D
B
The area of the shaded rectangle is:
Area = Height × Width = $40 per room × 5,000
rooms = $200,000
40
20
0
E
Area = tax
revenue
6
5,000
10,000
15,000
Quantity of hotel rooms
Revenue from an Excise Tax
• General Principle:
The revenue collected by an excise tax is equal
to the area of the rectangle whose height is
the tax wedge between the supply and
demand curves and whose width is the
quantity transacted under the tax.
Tax Rates and Revenue
• From graph above, $40 per room is the tax
rate on hotel rooms
• Tax rate is the amount of tax levied per unit
of whatever is being taxed
• Tax rates can be in dollar amount per unit of
good or service
• Or they are defined as the percentage of the
price
Tax Rates and Revenue
• Relationship between tax rates and revenue:
• Not a one-for-one relationship
• Generally, doubling the excise tax rate on a good
or service won’t double the amount of revenue
collected, because the tax increase will reduce
the quantity of the good or service transacted
• This relationship is not always positive, some
cases raising the tax rate actually reduces the
amount of revenue the government collects
Tax Rates and Revenue
(a) An excise tax of $20
Price of
hotel
room
(b) An excise tax of $60
Price of
hotel
room
$140
$140
120
120
Excise
tax =
$20 per
room
90
80
70
E
Area = tax
revenue
D
Excise
tax =
$60 per
room
80
Area = tax revenue
110
S
S
E
D
50
40
40
20
20
0
6,000
7,500 10,000
15,000
Quantity of hotel rooms
0
2,500 5,000
10,000
15,000
Quantity of hotel rooms
Tax Rates and Revenue
• Setting a tax rate high deters a significant
number of transactions which is likely to lead
to a fall in tax revenue
• Two ways to think about this:
• 1. tax increase means that the government
raises more revenue for each unit of the good
sold, which other think equal would lead to a
rise in tax revenue
Tax Rates and Revenue
2. The tax increase reduces the quantity of
sales, which other thinks equal would lead
to a fall in tax revenue
• What is the end result?
• Depends both on the price elasticizes of
supply and demand and on the initial level
of tax
Tax Rates and Revenue
• If the price elasticities of both supply and demand
are low, the tax increase won’t reduce the quantity of
the good sold very much, so that the tax revenue
would definitely rise
• If the price elasticities are high, the result is less
certain; of they are high enough, the tax reduces the
quantitative sold so much that the tax revenue falls
• Also, if the initial tax rate is low, the government
doesn't lose much revenue from the decline in the
quantity of the good sold, so the tax increase will
definitely increase tax revenue
Tax Rates and Revenue
• Also, if the initial tax rate is low, the government
doesn't lose much revenue from the decline in
the quantity of the good sold, so the tax
increase will definitely increase tax revenue
• If the initial tax rate is high, the result again is
less certain
• Tax revenue is likely to fall or rise very little from
a tax increase only in cases where the price
elasticities are high and there is already a high
tax rate
The Costs of Taxation
• What is the cost of taxation?
• Actually, a tax, like a quota, prevents mutually
beneficial transactions from occurring
• Remember the tax on hotel rooms?
• Due to the wedge created by the tax, some
transactions don’t occur that would have
occurred without the tax
• Remember deadweight loss?
– The cost to society is inefficient—the value of the
forgone mutually beneficial transactions
A Tax Reduces Consumer and Producer Surplus
Pr ic e
Fall in consumer surplus
due to tax
P
C
A
Excise tax
=T
P
B
E
E
F
C
P
S
P
Fall in producer surplus
due to tax
Q
T
Q
E
D
Quantity
Tax Rates and Revenue
• A fall in the price of a good generates a gain in
consumer surplus.
• Similarly, a price increase causes a loss to
consumers.
• So it’s not surprising that in the case of an excise
tax, the rise in the price paid by consumers
causes a loss.
• Meanwhile, the fall in the price received by
producers leads to a fall in producer surplus.
 A tax reduces both, the CS and the PS
Tax Rates and Revenue
• Using a triangle to measure deadweight loss
is a technique used in many economic
applications
– Used to measure deadweight loss produces by
types of taxes other than excise tax, used to
measure deadweight loss produced by
monopolies, used to evaluate the benefits and
costs of public policies because taxation
Tax Rates and Revenue
• When looking at the total amount of inefficiency
caused by a tax, we must also take into account
resources actually used by the government to
collect the tax, and by taxpayers to pay it, over
and above the amount of the tax
• Administrative costs of taxes are the resources
lost
– i.e. the amount of time people spend filling out their
income tax forms and or the money they spend
paying someone else to prepare their tax forms
Tax Rates and Revenue
• The total inefficiency caused by a tax is the
sum of its deadweight loss and its
administrative costs. The general rule for
economic policy is that, other things equal, a
tax system should be designed to minimize
the total inefficiency it imposes on society.
Elasticities and the Deadweight Loss of a Tax
• We know (hopefully) that the deadweight loss
from an excise tax arises because it prevents
some mutually beneficial transactions from
occurring
• The producer and consumer surplus that is
forgone because of these missing transactions is
equal to the size of the deadweight loss itself
• Larger the number of transactions that are
prevented by the tax, the larger the deadweight
loss
Elasticities and the Deadweight Loss of a Tax
• To minimize the efficiency costs of taxation,
one should choose to tax only those goods
for which demand or supply, or both, is
relatively inelastic.
• For such goods, a tax has little effect on
behavior because behavior is relatively
unresponsive to changes in the price.
Elasticities and the Deadweight Loss of a Tax
• In the extreme case in which demand is perfectly inelastic
(a vertical demand curve), the quantity demanded is
unchanged by the imposition of the tax. As a result, the
tax imposes no deadweight loss.
• Similarly, if supply is perfectly inelastic (a vertical supply
curve), the quantity supplied is unchanged by the tax and
there is also no deadweight loss
• If the goal in choosing whom to tax is to minimize
deadweight loss, then taxes should be imposed on goods
and services that have the most inelastic response—that
is, goods and services for which consumers or producers
will change their behavior the least in response to the tax.
Deadweight Loss and Elasticities
(a) Elastic Demand
Price
(b) Inelastic Demand
Price
S
Deadweight loss
is larger when
demand is elastic
S
P
C
Excise
tax = T
P
C
P
E
E
Excise
tax = T
P
E
P
P
E
D
Deadweight loss
is smaller when
demand is
inelastic
P
P
D
Q
T
Q
E
Quantity
Q Q
T E
Quantity
Deadweight Loss and Elasticities
(c) Elastic Supply
(d) Inelastic Supply
Price
Price
S
Deadweight
loss is larger
when supply is
elastic
P
C
S
P
C
Excise
tax = T
P
E
P
P
E
Excise
tax = T
P
E
E
Deadweight
loss is smaller
when supply
is inelastic
P
P
D
Q
T
Q
E
D
Quantity
Q Q
T E
Quantity
Elasticities and the Deadweight Loss of a Tax
• From the graphs, it is easily seen that to
minimize the efficiency costs of taxation, you
should choose to tax only those goods for
which demand or supply, or both, is relatively
inelastic
• For these goods, tax has little effect on the
behavior because behavior is relatively
unresponsive to changes in the price