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Chapter 8 of Taxation
8 APPLICATION: THE COSTS OF
TAXATION
WHAT’S NEW IN THE SEVENTH EDITION:
A new In the News box on “The Tax Debate” has been added.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
? how taxes reduce consumer and producer surplus.
? the meaning and causes of the deadweight loss from a tax.
? why some taxes have larger deadweight losses than others.
? how tax revenue and deadweight loss vary with the size of a tax.
CONTEXT AND PURPOSE:
Chapter 8 is the second chapter in a three-chapter sequence dealing with welfare economics. In the
previous section on supply and demand, Chapter 6 introduced taxes and demonstrated how a tax affects the price and quantity sold in a market. Chapter 6 also described the factors that determine how the burden of the tax is divided between the buyers and sellers in a market. Chapter 7 developed welfare economics—the study of how the allocation of resources affects economic well-being. Chapter 8 combines the lessons learned in Chapters 6 and 7 and addresses the effects of taxation on welfare. Chapter 9 will address the effects of trade restrictions on welfare.
The purpose of Chapter 8 is to apply the lessons learned about welfare economics in Chapter 7 to the issue of taxation that was addressed in Chapter 6. Students will learn that the cost of a tax to buyers and sellers in a market exceeds the revenue collected by the government. Students will also learn about the factors that determine the degree by which the cost of a tax exceeds the revenue collected by the government.
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KEY POINTS:
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A tax on a good reduces the welfare of buyers and sellers of the good, and the reduction in
consumer and producer surplus usually exceeds the revenue raised by the government. The fall in total surplus—the sum of consumer surplus, producer surplus, and tax revenue—is called the deadweight loss of the tax.
Taxes have deadweight losses because they cause buyers to consume less and sellers to produce less, and these changes in behavior shrink the size of the market below the level that maximizes total surplus. Because the elasticities of supply and demand measure how much market participants respond to market conditions, larger elasticities imply larger deadweight losses.
As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. Because a tax reduces the size of a market, however, tax revenue does not continually increase. It first rises with the size of a tax, but if the tax gets large enough, tax revenue starts to fall.
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CHAPTER OUTLINE:
I. The Deadweight Loss of Taxation
A. Remember that it does not matter who a tax is levied on; buyers and sellers will likely share in
the burden of the tax.
B. If there is a tax on a product, the price that a buyer pays will be greater than the price the seller
receives. Thus, there is a tax wedge between the two prices and the quantity sold will be smaller if there was no tax. Figure 1
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C. How a Tax Affects Market Participants
1. We can measure the effects of a tax on consumers by examining the change in consumer
surplus. Similarly, we can measure the effects of the tax on producers by looking at the change in producer surplus.
2. However, there is a third party that is affected by the tax—the government, which gets total
tax revenue of T × Q. If the tax revenue is used to provide goods and services to the public, then the benefit from the tax revenue must not be ignored.
If you spent enough time covering consumer and producer surplus in Chapter 7, students should have an easy time with this concept. Figure 2 3. Welfare without a Tax
Figure 3
a. Consumer surplus is equal to: A + B + C.
4. Welfare with a Tax
a. Consumer surplus is equal to: A. b. Producer surplus is equal to: D + E + F.
c. Total surplus is equal to: A + B + C + D + E + F.
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b. Producer surplus is equal to: F. c. Tax revenue is equal to: B + D.
d. Total surplus is equal to: A + B + D + F.
6. Definition of deadweight loss: the fall in total surplus that results from a market distortion, such as a tax. D. Deadweight Losses and the Gains from Trade
c. Tax revenue changes by: +(B + D). d. Total surplus changes by: –(C + E). 5. Changes in Welfare
a. Consumer surplus changes by: –(B + C). b. Producer surplus changes by: –(D + E).
Figure 4
1. Taxes cause deadweight losses because they prevent buyers and sellers from benefiting from
trade.
2. This occurs because the quantity of output declines; trades that would be beneficial to both
the buyer and seller will not take place because of the tax. Show the students that the nature of this deadweight loss stems from the reduction in the quantity of the output exchanged. Stress the idea that goods that are not produced, consumed, or taxed do not generate benefits for anyone. 3. The deadweight loss is equal to areas C and E (the drop in total surplus).
4. Note that output levels between the equilibrium quantity without the tax and the quantity
with the tax will not be produced, yet the value of these units to consumers (represented by the demand curve) is larger than the cost of these units to producers (represented by the supply curve).
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II. The Determinants of the Deadweight Loss Figure 5
A. The price elasticities of supply and demand will determine the size of the deadweight loss that
occurs from a tax.
1. Given a stable demand curve, the deadweight loss is larger when supply is relatively elastic.
2. Given a stable supply curve, the deadweight loss is larger when demand is relatively elastic. B. Case Study: The Deadweight Loss Debate
1. Social Security tax and federal income tax are taxes on labor earnings. A labor tax places a
tax wedge between the wage the firm pays and the wage that workers receive.
2. There is considerable debate among economists concerning the size of the deadweight loss
from this wage tax.
3. The size of the deadweight loss depends on the elasticity of labor supply and demand, and
there is disagreement about the magnitude of the elasticity of supply.
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