Chapter+8+-+Micro

Ch. 8 The Costs of Taxation

"Taxes are what we pay for civilized society." - Oliver Wendell Holmes Jr. How do taxes affect welfare, the economic well-being of participants in a market?

 THE DEADWEIGHT LOSS OF TAXATION
When the tax is enacted, the price paid by buyers rises, and the price received by sellers falls. They share the burden of the tax, whether it is levied on sellers or buyers.

How a Tax Affects Market Participants
To figure out how a tax affects market participants, we need to find out the benefit received by buyers, sellers, and the government. We already learned that the benefit received by buyers and sellers are measured by consumer surplus and producer surplus. To calculate total tax revenue, which is the benefit government receives, we multiply the size of the tax by the quantity of the good sold. (T x Q)



When a tax is enacted, tax revenue rises (when there's no tax, there's no tax revenue), consumer surplus decreases, and producer surplus decreases. In other word, the tax makes the government better off but buyers and sellers worse off. However, the losses to buyers and sellers from a tax exceed the revenue raised by the government due to the deadweight loss. Deadweight loss is created when a tax distorts a market outcome. Why do taxes impose deadweight losses? This is because when a tax raises the price to buyers and lowers the price to sellers, buyers want to consume less and sellers want to produce less. Therefore, the market size shrinks, and as a result deadweight loss is created.

THE DETERMINANTS OF THE DEADWEIGHT LOSS
What determines the size of a tax? It's the price elasticities of supply and demand. The deadweight loss is larger when the supply curve is more elastic. Similarly, when the demand curve is more elastic, the deadweight loss from the tax is larger. Since the elasticities of supply and demand measure how much sellers and buyers respond to the changes in price, they determine how much the tax distorts the market outcome.

 DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY
What happens to the deadweight loss and tax revenue when the size of a tax changes? The deadweight loss increases as the size of a tax rises. Actually, it rises even more rapidly than the size of the tax. For the government's tax revenue, the story is little bit different. At first, as the size of a tax increases, tax revenue also grows. However, as the size of the tax increases further, tax revenue starts to fall because the higher tax drastically reduces the size of the maket. People would just stop buying and selling the good if the tax gets too large.

Laffer curve shows the relationship between tax revenue and the size of a tax.

media type="youtube" key="54jr3Ceu894" height="344" width="425" This video is not directly related to the topic in this chapter, but you can watch how Barack Obama, who is recently elected as the next president of the United States, considers on the government's tax revenue.

Key Term
deadweight loss- decrease in total surplus in the market caused by market distortion such as tax

Summary
-When a tax is enacted, producers and consumers are worse off and the government is better off. Total surplus goes down however, due to the deadweight loss. -Taxes cause deadweight loss because they prevent buyers and sellers from realizing some of the gains from trade. -Size of the deadweight loss depends on the elasticity of supply curve and demand curve. -As a tax grows, deadweight loss increases as well. Tax revenue increases at first, but it starts to fall if a tax is too large.

Problems
1. When the size of a tax doubles, by how much does deadweight loss increase? A: The deadweight loss increases by a factor of 4.

2. Why does tax revenue fall if the size of a tax gets too large? A: If the size of a tax gets too large, many buyers and sellers exit the market causing it to shrink.

3. Which market will experience the largest deadweight loss? a. market with elastic supply curve and elastic demand curve b. market with elastic supply and inelastic demand curve c. market with inelastic supply curve and elastic demand curve d. market with inelastic supply curve and inelastic supply curve A: a.