Chapter 8

APPLICATION: THE COSTS OF TAXATION

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

Ø how taxes reduce consumer and producer surplus.

Ø the meaning and causes of the deadweight loss from a tax.

Ø why some taxes have larger deadweight losses than others.

Ø how tax revenue and deadweight loss vary with the size of a tax.

CONTEXT AND PURPOSE:

Chapter 8 is the second chapter in a three-chapter sequence dealing with welfare economics. In the previous section on supply and demand, Chapter 6 introduced taxes and demonstrated how a tax affects the price and quantity sold in a market. Chapter 6 also described the factors that determine how the burden of the tax is divided between the buyers and sellers in a market. Chapter 7 developed welfare economics—the study of how the allocation of resources affects economic well-being. Chapter 8 combines the lessons learned in Chapters 6 and 7 and addresses the effects of taxation on welfare. Chapter 9 will address the effects of trade restrictions on welfare.

The purpose of Chapter 8 is to apply the lessons learned about welfare economics in Chapter 7 to the issue of taxation that was addressed in Chapter 6. Students will learn that the cost of a tax to buyers and sellers in a market exceeds the revenue collected by the government. Students will also learn about the factors that determine the degree by which the cost of a tax exceeds the revenue collected by the government.

KEY POINTS:

1. A tax on a good reduces the welfare of buyers and sellers of the good, and the reduction in consumer and producer surplus usually exceeds the revenue raised by the government. The fall in total surplus—the sum of consumer surplus, producer surplus, and tax revenue—is called the deadweight loss of the tax.

2. Taxes have deadweight losses because they cause buyers to consume less and sellers to produce less, and this change in behavior shrinks the size of the market below the level that maximizes total surplus. Because the elasticities of supply and demand measure how much market participants respond to market conditions, larger elasticities imply larger deadweight losses.

3. 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.

CHAPTER OUTLINE:

I. The Deadweight Loss of Taxation

A. Remember that it does not matter who a tax is levied on; buyers and sellers will likely share in the burden of the tax.

B. If there is a tax on a product, the price that a buyer pays will be greater than the price the seller receives. Thus, there is a tax wedge between the two prices and the quantity sold will be smaller if there was no tax.

C. How a Tax Affects Market Participants

1. We can measure the effects of a tax on consumers by examining the change in consumer surplus. Similarly, we can measure the effects of the tax on producers by looking at the change in producer surplus.

2. However, there is a third party that is affected by the tax—the government, which gets total tax revenue of T × Q. If the tax revenue is used to provide goods and services to the public, then the benefit from the tax revenue must not be ignored.

3. Welfare Before a Tax

a. Consumer surplus is equal to: A + B + C.

b. Producer surplus is equal to: D + E + F.

c. Total surplus is equal to: A + B + C + D + E + F.

4. Welfare with Tax

a. Consumer surplus is equal to: A.

b. Producer surplus is equal to: F.

c. Tax revenue is equal to: B + D.

d. Total surplus is equal to: A + B + D + F.

5. Changes in Welfare

a. Consumer surplus changes by: –(B + C)

b. Producer surplus changes by: –(D + E)

c. Tax revenue changes by: +(B + D)

d. Total surplus changes by: –(C + E)

6. Definition of deadweight loss: the fall in total surplus that results from a market distortion, such as a tax.

D. Deadweight Losses and the Gains from Trade

1. Taxes cause deadweight losses because they prevent buyers and sellers from benefiting from trade.

2. This occurs because the quantity of output declines; trades that would be beneficial to both the buyer and seller will not take place because of the tax.

3. The deadweight loss is equal to areas C and E (the drop in total surplus).

4. Note that output levels between the equilibrium quantity without the tax and the quantity with the tax will not be produced, yet the value of these units to consumers (represented by the demand curve) is larger than the cost of these units to producers (represented by the supply curve).

II. The Determinants of the Deadweight Loss

A. The price elasticities of supply and demand will determine the size of the deadweight loss that occurs from a tax.

1. Given a stable demand curve, the deadweight loss is larger when supply is relatively elastic.

2. Given a stable supply curve, the deadweight loss is larger when demand is relatively elastic.

B. Case Study: The Deadweight Loss Debate

1. Social Security tax and federal income tax are taxes on labor earnings. A labor tax places a tax wedge between the wage the firm pays and the wage that workers receive.

2. There is considerable debate among economists concerning the size of the deadweight loss from this wage tax.

3. This is because the size of the deadweight loss depends on the elasticity of labor supply and demand, and there is disagreement about the magnitude of the elasticity of supply.

a. Economists who argue that labor taxes are not very distorting believe that labor supply is fairly inelastic.

b. Economists who argue that labor taxes lead to large deadweight losses believe that labor supply is more elastic.

C. FYI: Henry George and the Tax on Land

1. Henry George was a 19th century economist who suggested that the government use only a single tax on land to raise revenue.

2. Note that the burden of a tax falls more heavily on the side of the market that is less elastic. Since the supply of land is fixed, the supply of land is a vertical line and the elasticity is equal to zero. Thus, landowners bear the entire burden of the tax.

3. There would also be no tax wedge in this case because the supply curve is vertical and this implies that there is no deadweight loss (because the government’s tax revenue is exactly equal to the landowners’ losses).

4. However, the tax would occur without a deadweight loss only if it was a tax on raw land rather than improvements on the land.

III. Deadweight Loss and Tax Revenue as Taxes Vary

A. As taxes increase, the deadweight loss from the tax increases.

B. In fact, as taxes increase, the deadweight loss rises more quickly than the size of the tax.

1. The deadweight loss is the area of a triangle and the area of a triangle depends on the square of its size.

2. If we double the size of a tax, the base and height of the triangle both double so the area of the triangle (the deadweight loss) rises by a factor of four.

C. As the tax increases, the level of tax revenue will eventually fall.

D. Case Study: The Laffer Curve and Supply-Side Economics

1. The relationship between the size of a tax and the level of tax revenues is called a Laffer Curve.

2. Supply-side economists in the 1980s used the Laffer curve to support their belief that a drop in tax rates could lead to an increase in tax revenue for the government.

3. When taxes rates were lowered after Reagan took office, revenue from personal income taxes fell while personal incomes rose.

4. However, tax revenues collected from the richest Americans did rise when their tax rates were cut.

5. The important lesson that must be learned is that we cannot predict how much tax revenues will change in response to a change in tax rates just by looking at the tax rates themselves. The government must understand how a change in tax rates will affect individuals’ behavior.