Chapter 8: The Costs of Taxation

what does the distribution of a tax burden depend on

elasticities of supply and demand, NOT who is being taxed

what does a tax on a good do to the market for that good?

it shrinks the market for that good and the quantity sold decreases

what is the welfare of buyers measured by

consumer surplus

what is the welfare of sellers measured by

producer surplus

how do we measure government surplus (tax revenue)

tax multiplied by the quantity sold

with a tax included, what is the total surplus

consumer surplus + producer surplus + tax revenue

**we assume that tax revenue gets used for a benefit

**this value should be less than the total revenue without a tax because of DWLw

with a tax, what are the changes in welfare?

consumer surplus falls, producer surplus falls, tax revenue rises

**the losses to buyers and sellers from a tax exceed the revenue raised by the government

deadweight loss

total fall in surplus resulting from a tax that distorts outcomes

why do taxes cause deadweight loss?

people respond to incentives - with a tax, it raises the price buyers pay and lowers the price selelrs receive, therefore bueyrs ocnsume less and sellers produce less, so the market shrinks below its optimum, causing inefficiency

taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade

what determines whhether the deadweight loss from a tax is large or small?

price elasticities of supply and demand

what is the rule for how large deadweight loss is

the greater the elasticities of supply and demand, the larger the DWL of a tax

what is the most important source of government revenue

income tax

marginal tax rate

the tax on the last dollar of earnings, = 40% in US

do economists think the labor tax has a small or large DWL?

some think it has a large DWL, some think it has a small DWL. this disagreement arises because econoimsts hold different views about the elasticity of labor supplywhat

what are the different views about labor supply elasticity?

economists who say labor taxes don’t greatly distort market outcomes say that labor supply is fairly inelastic, saying that most people work full-time regardless of the wage —> small DWL

economists who say labor taxes are highly distortionary say thta labor supply is more elastic bc there are some groups that respond more to incentives i.e. working overtime, having second earners, choosing when to retire, working in the underground economy (“paying under the table”)

how does deadweight loss increase with an increase in the tax compared to tax revenue?

if we double the size of a tax, the DWL will quadruple in size

laffer curve

shows that initially, as the size of a tax increases, the DWL loss quickly gets larger but the tax revenue also increases. however, past a certain point, increasing the tax rate leads to a loss in tax revenue.