Chapter 8 - Application: The Costs of Taxation

8.1 The Deadweight Loss of Taxation

How Tax Affects Market Participants:

• Benefit for buyers is measured by consumer surplus- the amount buyers are willing to pay for the good minus the amount they actually pay for

• Benefit for sellers is measured by producer surplus- the amount sellers receive for the good minus their costs (Chapter 7 Review)

• The government gets total tax revenue of T (the size of the tax) multiplies Q (the quantity of the good sold)

  • Tax revenue can be used to produce services, such as roads, police, public education, or to help the ones in need, etc
  • We use the government’s tax revenue to measure the public benefit from tax

  

  

• Welfare without tax= no tax revenue

• Welfare with tax= price paid by buyers rises and government collects tax revenue

• Change in Welfare

• Deadweight loss- the fall in total surplus that results from a market distortion, such as a tax

• When a tax raises the price to buyers and lowers the price to sellers, it distorts incentives and causes markets to allocate resources inefficiently

Deadweight Losses and the Gains from Trade:

• Taxes cause deadweight losses It prevents buyers and sellers from realizing some of the gains from trade

• The gains

  • The difference between buyers’ value and sellers’ cost is less than the tax

  

8.2 The Determinants of the Deadweight Loss

• The price elasticities of supply and demand

  • Determines whether the deadweight loss from a tax is large or small

  

The Deadweight Loss Debate:

• Economists argue that labor taxes do not greatly distort market outcomes and believe that labor supply is fairly inelastic. Some examples are…

  • Many workers can adjust the number of hours they work for a higher or lesser wage
  • Some families have second earners who have often married women with children
  • Elderlies retiring and their wages are all up to their own decisions
  • Some people engage in illegal economic activity to avoid paying taxes
  • Known as the underground economy

• Many disagreements in whether the government should provide more services or reduce the tax burden

  • This is because of different views about the elasticity of labor supply and the deadweight loss of taxations

  

8.2 Deadweight Loss and Tax Revenue as Taxes Vary

• Taxes fluctuates
• As the size of tax increases, its deadweight loss quickly gets larger