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