Transcript Price

Application: The
Costs of Taxation
8
Application: 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.
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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
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How a Tax Affects Market Participants
• 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.
• Buyers pay higher price, than in the absence of
tax. Sellers receive lower price.
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Figure 2 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
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Figure 3 How a Tax Effects 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
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How a Tax Affects Welfare
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How a Tax Affects Market Participants
• A deadweight loss is the fall in total surplus that
results from a market distortion, such as a tax.
• Taxes cause deadweight losses because they
prevent buyers and sellers from realizing some
of the gains from trade.
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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
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DETERMINANTS OF THE
DEADWEIGHT LOSS
• What determines whether the deadweight loss
from a tax is large or small?
• The magnitude of the deadweight loss depends on
how much the quantity supplied and quantity
demanded respond to changes in the price.
• That, in turn, depends on the price elasticities of
supply and demand.
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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
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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
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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
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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
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DETERMINANTS OF THE
DEADWEIGHT LOSS
• The greater the elasticities of demand and
supply:
• the larger will be the decline in equilibrium
quantity and,
• the greater the deadweight loss of a tax.
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DEADWEIGHT LOSS DEBATE
• Example of taxes – labor market
• If labor is inelastic – DWL is small
• If labor supply is elastic – DWL is large
• Workers can adjust the number of hours they work
• Elderly who can choose when to retire
• Workers in the legitimate vs. underground economy
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Labor Taxes
Country
Tax Rate
Workweek
Italy
64%
16.5
France
59%
17.5
Germany
59%
19.3
Canada
52%
22.8
UK
44%
22.9
US
40%
25.9
Japan
37%
27.0
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DEADWEIGHT LOSS AND TAX
REVENUE AS TAXES VARY
• For a 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.
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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
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
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
Figure 7 How Deadweight Loss and Tax Revenue Vary
with the Size of a Tax
(a) Deadweight Loss
Deadweight
Loss
0
Tax Size
Figure 7 How Deadweight Loss and Tax Revenue Vary
with the Size of a Tax
(b) Revenue (the Laffer curve)
Tax
Revenue
0
Tax Size
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.
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Summary
• A tax on a good reduces the welfare of buyers
and sellers of the good
• The fall in total surplus—the sum of consumer
surplus, producer surplus, and tax revenue — is
called the deadweight loss of the tax.
• Taxes have a deadweight loss because they
cause buyers to consume less and sellers to
produce less.
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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.
• Eventually, however, a larger tax reduces tax
revenue because it reduces the size of the
market.
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