Chapter 8 The Costs of Taxation PDF

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Chapter 8...

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Chapter 8 The Cost of Taxation Recall that when a per-unit tax (exercise tax) is imposed on a good:    

If the tax is levied on the buyers, then the demand curve shifts downward (to the left) by the size of the tax If the tax is levied on sellers, then the supply curve shifts upward (to the left) by the size of the tax In both cases there is the same outcome. The price paid by buyers rises, the price received by sellers falls and the quantity sold decreases (the market for the good is smaller) The tax burden is distributed between producers and consumers based on the elasticities of supply and demand

To determine how an exercise tax affects market participants we determine:   

Total tax revenue for the government (public benefit) Consumer surplus with and without the tax Producer surplus with and without the tax

Without the tax, welfare is equal to: Total Surplus = Consumer Surplus + Producer Surplus With the tax, welfare is equal to: Consumer Surplus + Producer Surplus + Tax Revenue Where tax revenue = Tax * Quantity sold

 The tax raises the price to buyers and decreases the price to sellers; therefore it gives buyers an incentive to consume less and sellers and incentive to produce less than they would in the absence of the tax  An exercise tax reduces consumer surplus and producer surplus. The fall in producer and consumer surplus exceeds tax revenues, therefore the tax imposes a loss Deadweight Loss The fall in total surplus that results from a market distortion like a tax\    

Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade. The value to buyers of the units are not sold is greater than the cost of producing them The difference between buyers’ value and sellers’ cost represents from the gains from trade. Since the gains from trade are less than the tax, these trades are not made and the deadweight loss arises

Determinants of Deadweight Loss 

The size of the deadweight loss depends on the price elasticity and supply: -

The greater the elasticity of supply, the greater is the deadweight loss of a tax. The tax reduces the price receiver by the seller, so they sell less. The more elastic supply is, the easier it is for firms to leave the market, the less sellers will produce and therefore the greater is the effect of the tax.

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The greater the elasticity of demand, the greater is the deadweight loss of a tax. The tax raises the price paid by buyers so, they consume less. The more elastic demand is, the less buyers will consume and therefore the greater is the effect of the tax.

Deadweight Loss and Tax Revenues as Taxes Vary 

The larger the deadweight loss, the larger is the cost of any government program

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The size of a tax increases, its deadweight loss increases too. Tax revenues first increases with the size of the tax, however as the tax gets larger, the market shrinks so much that the tax revenue starts to fall....