Application: The Costs of Taxation
- Welfare economics: study of how resource allocation affects economic well-being.
- Buyers and sellers benefit from market participation.
- Market equilibrium maximizes total welfare.
THE DEADWEIGHT LOSS OF TAXATION
- Taxes impact economic well-being of market participants.
- Tax on buyers or sellers leads to price changes.
- Tax places a wedge between buyer and seller prices.
- Quantity sold falls below the untaxed level.
How a Tax Affects Market Participants
- Tax revenue: T (size of tax) * Q (quantity sold).
- Deadweight loss: fall in total surplus due to market distortion.
Changes in Welfare
- Change in consumer surplus.
- Change in producer surplus.
- Change in tax revenue.
- Deadweight loss exceeds government revenue.
Deadweight Losses and the Gains from Trade
- Taxes cause deadweight losses, preventing full gains from trade.
DETERMINANTS OF THE DEADWEIGHT LOSS
- Deadweight loss magnitude depends on elasticities of supply and demand.
The greater the elasticities of demand and supply:
- Larger decline in equilibrium quantity.
- Greater deadweight loss of a tax.
The Deadweight Loss Debate
- Labor taxes seen as highly distorting.
- Elastic labor supply examples: adjustable hours, second earners, elderly, underground economy.
DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY
- Deadweight loss rises more rapidly than tax size.
For the small tax:
As the tax size increases:
- Tax revenue grows initially.
- Market shrinks, tax revenue falls.
As the tax size continues to rise:
- Deadweight loss grows larger.
CASE STUDY: The Laffer Curve and Supply-side Economics
- Laffer curve: relationship between tax rates and revenue.
- Supply-side economics: tax cuts induce more work, potentially increasing tax revenues.
Summary
- Tax on a good reduces welfare for buyers and sellers.
- Deadweight loss includes reduced consumer and producer surplus, exceeding tax revenue.
- Taxes cause buyers to consume less and sellers to produce less.
- Larger taxes distort incentives more, increasing deadweight loss.
- Tax revenue initially rises, then falls as the tax size increases.
- The Laffer curve explores the relationship between tax rates and revenue in supply-side economics.