Chapter+8+Application+-+The+Costs+of+Taxation

Ch.8 The Costs of Taxation
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=**Table of Contents** = = = 1. Introduction 2. Key Topics and Lectures 3. Conclusion 4. Glossary 5. Summary 6. Mini Quiz 7. Answer Key 8. Citations

- Yena S.

 **__Introduction__**

In this chapter, we will look at the EFFECTS of taxes on welfare and on the economic well being of people in a market.

Hmm, let's see. The government puts taxes on people to raise revenue, which is used for public goods and services. As we saw in Chapter 6, both buyers and sellers are worse off when a good is taxed. A tax raises  the price buyers pay and lowers  the price sellers receive. But, to fully understand how taxes affect economic well-being, we must compare the REDUCED welfare of buyers and sellers to the amount of revenue the government raises. So... let's get it started! ;)

**__The Deadweight Loss of Taxation__**



A tax on a good places a wedge  between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls . Depending on where the tax is levied on, the supply or demand curve shifts. However, when a tax is levied on a product, the size of the market for that good shrinks because taxes distort  the market condition.

The deadweight loss <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;"> occurs when a tax is levied on a good. Therefore, the consumer surplus and the producer surplus both <span style="color: #d20f97; font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;">decrease <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;">. Since both surpluses are decreased, the total surplus also decreases. Compared to the welfare without a tax, it is clear that taxation has changed the welfare worse.




 * Tax Revenue = Quantity sold (Q) x Size of tax (T)**

The benefit received by buyers in a market is measured by consumer surplus - the amount buyers are willing to pay for the good minus the amount they actually pay for it. The benefit received by sellers in a market is measured by producer surplus - the amount sellers received for the good minus their costs. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 156%;"> <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 130%;">

A tax on a good <span style="color: #50dc4c; font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 130%;">reduces <span style="color: #d20f97; font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 130%;">consumer surplus <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 130%;"> (by the area B+C) and <span style="color: #d20f97; font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 130%;">producer surplus <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 130%;"> (by the area D+E). Because the fall in producer and consumer surplus exceeds tax revenue (area B+D), the tax is said to impose a DEADWEIGHT LOSS (area C+E). <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;">Changes in Welfare: Buyers and sellers are WORSE OFF. The government is BETTER OFF. The changes in consumer surplus and producer surplus are both <span style="color: #d20f97; font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;">negative <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;">. The losses to buyers and sellers form a tax <span style="color: #d20f97; font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;">exceed <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;"> the revenue raised by the government. When a tax raises the price of a product, the market tends to have <span style="color: #50dc4c; font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;">less <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;"> incentives from buyers and producers.

Deadweight Losses and the Gains from Trade:



Taxes cause DWL because they prevent buyers and sellers from realizing some of the gains from trade.

When the government imposes a tax on a good, the quantity sold <span style="color: #50dc4c; font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;">falls <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;"> from Q1 to Q2. At every quantity between Q1 and Q2, the potential gains from trade among buyers and sellers do not get realized. These lost gains from trade create the DWL.

__**The Determinants of the Deadweight Loss**__

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;"> <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;"> <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;"> Price elasticities of the supply and demand determine the size of dead weight loss.

The <span style="color: #50dc4c; font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">greater <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;"> elasticities of supply and demand, the <span style="color: #50dc4c; font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">greater <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;"> the deadweight loss. More tax equals more revenue and more deadweight loss. Yet, deadweight loss rises faster than the size of the tax revenue. Deadweight loss continually <span style="color: #d20f97; font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">increases <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;"> as tax increases. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;"> __**DWL and Tax Revenue as Taxes Vary**__

Let's keep in mind that the DWL is the reduction in total surplus due to the tax, and that tax revenue is the amount of the tax times the amount of the good sold. DWL and tax revenue vary when the size of a tax varies.

__**The Laffer Curve**__



Tax revenue first rises and then falls.

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;">We should understand that how much revenue the government gains or loses from a tax change cannot be computed just by looking at tax rate, for it also depends on how the tax change affects people's behavior.

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;">__**Glossary**__

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 124.8%;">Deadweight Loss: the fall in total surplus that results from a market distortion, such as a tax.

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">**__Summary__**


 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">Taxes reduces the welfare of both buyers and sellers of the good.
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">Taxes cause the deadweight loss!
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">Taxing cause the total surplus to fall: consumer surplus decreases and producer surplus decreases.
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">Increase in tax distorts the incentives more, and this will cause the deadweight loss to increase more as well.
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">In other words, increase in deadweight loss will cause the increase in tax size.
 * <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">As the tax size increases, the tax revenue increase but decreases back again.

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">**__Mini Quiz__**

1. When a tax is imposed on a good we know that the losses to buyers and sellers A. are equal to the revenue raised by the government. B. are less than the revenue raised by the government. C. exceed the revenue raised by the government. D. cannot be compared to the tax revenue raised by the government since the amount of the tax will vary from good to good.

2. Taxes cause DWL because A. they transfer purchasing power to the government which always wastes money. B. they prevent buyers and sellers from realizing some of the gains from trade. C. marginal buyers and sellers leave the market causing the quantity sold to fall. D. Both b and c are correct.

3. Which of the following statements is true for most markets? A. As the tax rate increases, tax revenue continually rises and DWL continually falls. B. As the tax rate rises, tax revenue rises for a while, but eventually begins to fall; DWL rises but also begins to fall as tax revenue falls. C. As the tax rate rises, tax revenue rises for a while, but eventually begins to fall; DWL continually rises. D. As the tax rate rises, tax revenue rises for a while, but eventually begins to fall; DWL falls for a while, but begins to rise as tax revenue falls.

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">__**Answer Key**__

1. C 2. D 3. C

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 120%;">__**Citations**__

http://www.nicholsoncartoons.com.au/cartoons/new/2003-09-24%20Tax%20man%20should%20be%20more%20efficient%20350wb.JPG All the graph images that are not hand drawn are from: http://www.swlearning.com/economics/mankiw/mankiw3e/powerpoint_micro.html