Chapter 8

Application: The Costs of Taxation

In this chapter,
look for the answers to these questions:
• How does a tax affect consumer surplus, producer
surplus, and total surplus?
• What is the deadweight loss of a tax?
• What factors determine the size of this deadweight
loss?
• How does tax revenue depend on the size of the tax?

2
 Chapter Outline
1. The Deadweight Loss of Taxation
2. The Determinants of the Deadweight Loss
3. Deadweight Loss and Tax Revenue
1. The Deadweight Loss of Taxation

01/01/2022
Review from Chapter 6: Example of The Market for Pizza

Eq’m
Eq’m
w/o P
w/o tax
tax
S1

$10.00

D1

Q
500
 A Tax on Buyers
AA tax
tax on
on
buyers Effects of a $1.50 per
buyers shifts
shifts
the unit tax on buyers
the DD curve
curve P
down
down by by the
the
amount
amount of of S1
PB = $11.00
the Tax
the tax.
tax.
$10.00
PS = $9.50
The
The price
price
buyers
buyers pay
pay
D1
rises,
rises, the
the
price
price sellers
sellers D2
Q
receive
receive falls,
falls, 430 500
eq’m
eq’m Q Q falls.
falls.
CHAPTER 6 SUPPLY, DEMAND,
AND GOVERNMENT POLICIES
 The Incidence of a Tax:
how the burden of a tax is shared among
market participants
P
Because
Because
of S1
of the
the tax,
tax, PB = $11.00
Tax
buyers
buyers paypay
$10.00
$1.00
$1.00 more,
more,
PS = $9.50
sellers
sellers get
get
$0.50
$0.50 less.
less. D1
D2
Q
430 500

CHAPTER 6 SUPPLY, DEMAND,

AND GOVERNMENT POLICIES
 A Tax on Sellers
AA tax
tax on
on
sellers Effects of a $1.50 per
sellers shifts
shifts
the unit tax on sellers
the SS curve
curve P
up
up by
by the
the S2
amount
amount of of S1
PB = $11.00
the Tax
the tax.
tax.
$10.00
PS = $9.50
The
The price
price
buyers
buyers pay
pay
D1
rises,
rises, the
the
price
price sellers
sellers
Q
receive
receive falls,
falls, 430 500
eq’m
eq’m Q Q falls.
falls.
CHAPTER 6 SUPPLY, DEMAND,
AND GOVERNMENT POLICIES
 The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the same
whether the tax is imposed on buyers or sellers!
What matters P
is this: S1
PB = $11.00
A tax drives Tax
a wedge $10.00
between the PS = $9.50
price buyers
pay and the D1
price sellers
receive. Q
430 500
 Review from Chapter 6
• A tax
– drives a wedge between the price buyers pay and
the price sellers receive.
– raises the price buyers pay and lowers the price
sellers receive.
– reduces the quantity bought & sold.
• These effects are the same whether the tax is
imposed on buyers or sellers, so we do not
make this distinction in this chapter.
10
 The Effects of a Tax
P
Eq’m with no tax:
Price = PE
Quantity = QE Size of tax = $T
PB S
Eq’m with
tax = $T per unit: PE
Buyers pay PB PS D
Sellers receive PS
Quantity = QT
Q
QT QE

APPLICATION: THE COSTS OF TAXATION 11

 The Effects of a Tax
P

Revenue from tax:

$ T x QT Size of tax = $T
PB S

PE

PS D

Q
QT QE

APPLICATION: THE COSTS OF TAXATION 12

 The Effects of a Tax
• Next, we apply welfare economics to measure the gains and
losses from a tax.
• Tax revenue can fund beneficial services
(e.g., education, roads, police)
so we include it in total surplus.
• We determine gains and loses from tax
- Buyers: consumer surplus (CS),
- Sellers: producer surplus (PS),
- Government: tax revenue,
- total surplus
(with and without the tax).

13
 The Effects of a Tax
P
Without a tax,
CS = A + B + C
PS = D + E + F A
Tax revenue = 0 S
B C
Total surplus PE
D E
= CS + PS
=A+B+C D
F
+D+E+F

Q
QT QE

14
 The Effects of a Tax
P
With the tax,
CS = A
PS = F
A
Tax revenue PB S
=B+D B C
Total surplus D E
=A+B PS D
+D+F F
The tax reduces
total surplus by Q
C+E QT QE

15
 The Effects of a Tax
P

Deadweight Loss (DWL)

C + E is called the
deadweight loss A
(DWL) of the tax - PB S
the fall in total B C
surplus that E
D
results from a market PS D
distortion, such as a F
tax.

Q
QT QE

16
 About the Deadweight Loss
P
Because of the tax, the
units between
QT and QE are not
sold. S
PB
The value of these
units to buyers is
greater than the cost PS D
of producing them,
so the tax prevents
some mutually
Q
beneficial trades. QT QE

APPLICATION: THE COSTS OF TAXATION 17

A C T I V E L E A R N I N G 1:
Analysis of Tax The market for
P airplane tickets
A. Compute $ 400
CS, PS, and total 350
surplus without
300
a tax. S
250
B. If $100 tax
per ticket, 200
compute 150
D
CS, PS, 100
tax revenue, 50
total surplus,
0 Q
and DWL.
0 25 50 75 100 125 18
 2. The Determinants of the DWL

01/01/2022
 What Determines the Size of the DWL?
• Which goods or services should Goverment tax
to raise the revenue it needs?
 One answer: those with the smallest DWL.
• When is the DWL small or large?
 It depends on the price elasticities
of supply and demand.
• Recall:
The price elasticity of demand (or supply) measures
how much QD (or QS) changes
when P changes.

APPLICATION: THE COSTS OF TAXATION 20

 DWL and the Elasticity of Supply
When
When supply
supply P
isis inelastic,
inelastic, S
it’s
it’s harder
harder for
for firms
firms
to
to leave
leave the
the market
market
when
when the the tax
tax reduces
reduces
PPSS..
So, Size
So, the
the tax
tax only
only
of tax
reduces
reduces QQ aa little,
little,
and
and DWL
DWL isis small.
small. D
Q

APPLICATION: THE COSTS OF TAXATION 21

 DWL and the Elasticity of Supply
The
The moremore elastic
elastic isis P
supply,
supply,
the
the easier
easier for
for firms
firms
to
to leave
leave the
the market
market S
when
when the the tax
tax reduces
reduces
PPSS,, Size
of tax
the
the greater
greater Q
Q falls
falls
below
below the
the surplus-
surplus-
maximizing
maximizing quantity,
quantity, D
the
the greater
greater the
the DWL.
DWL. Q

APPLICATION: THE COSTS OF TAXATION 22

 Tax Distortions and Elasticities
(a) Inelastic Supply (b) Elastic Supply
When supply is relatively
Price inelastic, the deadweight Price When supply is relatively
loss of a tax is small elastic, the deadweight loss of
a tax is large
Supply
Supply

Size
of
Size tax
of tax
Demand
Demand

0 Quantity 0 Quantity

In panels (a) and (b), the demand curve and the size of the tax are the same, but the price
elasticity of supply is different. Notice that the more elastic the supply curve, the larger the
deadweight loss of the tax.
23
DWL and the Elasticity of Demand
P
When
When demand
demand
isis inelastic,
inelastic,
S it’s
it’s harder
harder for
for
consumers
consumers to to leave
leave
Size
the
the market
market when
when
of tax
the
the taxtax raises
raises PPBB..
So,
So, the
the tax
tax only
only
reduces
reduces QQ aa little,
little,
D and
and DWL
DWL isis small.
small.
Q

APPLICATION: THE COSTS OF TAXATION 24

DWL and the Elasticity of Demand
The
The more
more elastic
elastic isis
P demand,
demand,
S the
the easier
easier for
for buyers
buyers
to
to leave
leave the
the market
market
when
when thethe tax
tax
Size increases
increases PPBB,,
of tax
the
the more
more Q Q falls
falls below
below
D
the
the surplus-
surplus-
maximizing
maximizing quantity,
quantity,
and
and the
the greater
greater the
the
Q
DWL.
DWL.

APPLICATION: THE COSTS OF TAXATION 25

 Tax Distortions and Elasticities
(c) Inelastic Demand (d) Elastic Demand
When demand is relatively
inelastic, the deadweight loss When demand is relatively
Price Price
of a tax is small elastic, the deadweight loss
Supply of a tax is large Supply

Size Size
of of
tax tax
Demand

Demand

0 Quantity 0 Quantity

In panels (c) and (d), the supply curve and the size of the tax are the same, but the price
elasticity of demand is different. Notice that the more elastic the demand curve, the larger the
deadweight loss of the tax.
26
ACTIVE LEARNING 2
Elasticity and the DWL of a tax
Would the DWL of a tax be larger if the
tax were on:
A. Coca Cola or helmet?
B. Hotel rooms in the short run or
hotel rooms in the long run?
C. Groceries or meals at expensive restaurants?

27
ACTIVE LEARNING 3
Discussion question
• The government must raise tax revenue to pay
for schools, police, etc. To do this, it can
either tax groceries or meals at expensive
restaurants.
• Which should it tax?

28
 3. DWL and Tax

01/01/2022
 How Big Should the Government Be?
(The DWL Debate)
• A bigger government provides more services,
but requires higher taxes, which cause DWLs.
• The larger the DWL from taxation,
the greater the argument for smaller government.
• The tax on labor income is especially important;
it’s the biggest source of govt revenue.
• For the typical worker, the marginal tax rate
(the tax on the last dollar of earnings) is about 40%.
• How big is the DWL from this tax?
It depends on elasticity….

APPLICATION: THE COSTS OF TAXATION 30

 How Big Should the Government Be?

• If labor supply is inelastic, then this DWL is

small.
• Some economists believe labor supply is
inelastic, arguing that most workers work
full-time regardless of the wage.

APPLICATION: THE COSTS OF TAXATION 31

 How Big Should the Government Be?
Other economists believe labor taxes are highly distorting
because some groups of workers have elastic supply and
can respond to incentives:
– Many workers can adjust their hours,
e.g., by working overtime.
– Many families have a 2nd earner with discretion over
whether and how much to work.
– Many elderly choose when to retire based on the
wage they earn.
– Some people work in the “underground economy”
to evade high taxes.
APPLICATION: THE COSTS OF TAXATION 32
 The Effects of Changing the Size of the Tax

• Policymakers often change taxes, raising some

and lowering others.
• What happens to DWL and tax revenue when
taxes change? We explore this next….

APPLICATION: THE COSTS OF TAXATION 33

 DWL and the Size of the Tax
P
Initially, the tax is T new
per unit. DWL
Doubling the tax S
causes the DWL to
2T T
more than double.
D
initial
DWL

Q
Q2 Q1

APPLICATION: THE COSTS OF TAXATION 34

 DWL and the Size of the Tax
P
Initially, the tax is T new
per unit. DWL

Tripling the tax S

causes the DWL to
3T T
more than triple.
D
initial
DWL

Q
Q3 Q1

APPLICATION: THE COSTS OF TAXATION 35

How Deadweight Loss and Tax Revenue Vary with the Size of a Tax

(a) Small tax (b) Medium tax (c) Large tax

Price Price Price
Deadweight loss Deadweight loss Deadweight loss
PB
Supply Supply Supply
PB
PB

Tax revenue
Tax Tax
revenue revenue
PS
Demand PS Demand Demand

PS
0 Q2 Q1 0 Q2 Q1 0 Q2 Q1
Quantity Quantity Quantity
The deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the amount of the tax
times the amount of the good sold. In panel (a), a small tax has a small deadweight loss and raises a small
amount of revenue. In panel (b), a somewhat larger tax has a larger deadweight loss and raises a larger
amount of revenue. In panel (c), a very large tax has a very large deadweight loss, but because it has
reduced the size of the market so much, the tax raises only a small amount of revenue.

36
 DWL and the Size of the Tax
Implication
Implication Summary
When
When tax
tax rates
ratesare
are low,
low, When a tax increases,
raising
raising them
them doesn’t
doesn’t DWL rises even more.
cause DWL
cause much
much harm,
harm,andand
lowering
lowering them
them doesn’t
doesn’t
bring
bring much
much benefit.
benefit.
When
When tax
tax rates
ratesare
are
high,
high,raising
raising them
them isis
very
very harmful,
harmful, andand
cutting
cutting them
them isisvery
very
beneficial.
beneficial.
Tax size
APPLICATION: THE COSTS OF TAXATION 37
 Tax Revenue
Tax Revenue = Tax Rate x Taxable income

• Do raise in Tax Rates

cause Tax Revenue to
increase?
 Revenue and the Size of the Tax
When the P
tax is small,
increasing it
causes tax PB
S
revenue to rise. PB
2T T
PS D
PS

Q
Q2 Q1

APPLICATION: THE COSTS OF TAXATION 39

 Revenue and the Size of the Tax
P

PB
PB
S

When the 3T 2T
tax is larger,
increasing it D
causes tax PS
revenue to fall. PS
Q
Q3 Q2

APPLICATION: THE COSTS OF TAXATION 40

 Revenue and the Size of the Tax

The Laffer curve

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

Tax size

APPLICATION: THE COSTS OF TAXATION 41

 The Laffer Curve

Tax revenue ($ billions) 400

A
300

B
200

100

0
0 48 85 100
Tax rate (%)

42
CHAPTER SUMMARY

• A tax on a good reduces the welfare of buyers and

sellers. This welfare loss usually exceeds the revenue
the tax raises for the govt.
• The fall in total surplus (consumer surplus, producer
surplus, and tax revenue) is called the deadweight loss
(DWL) of the tax.
• A tax has a DWL because it causes consumers to buy
less and producers to sell less, thus shrinking the
market below the level that maximizes total surplus.

43
CHAPTER SUMMARY

• The price elasticities of demand and supply measure

how much buyers and sellers respond to price changes.
Therefore, higher elasticities imply higher DWLs.
• An increase in the size of a tax causes the DWL to rise
even more.
• An increase in the size of a tax causes revenue to rise at
first, but eventually revenue falls because the tax
reduces the size of the market.

44
• Read chapter 8 textbook
• Exercise 1,3,4,5,6,7&10
• Page 165,166 text book
• B’s demand and supply curves are as follows:
(P: $, Q: unit)
P = 3Q – 12
P = 18 – 2Q
a. Calculate equilibrium price and quantity
b. Suppose the Government tax 5$/unit on sellers. Calculate price
buyers pay, price seller sells, tax revenue and DWL
c. The government sets up the price ceiling at 4$/unit and supply
the shortage. Calculate the actual price and quantity in the
market. Calculate expenditure of the Government.
d. Suppose that the government wants the price and quantity to
be equal to the result in question (c) but by subsidy for producer
rather than by setting ceiling price. Calculate the subsidy level per
unit. In this case, who will get more benefit, supplier or consumer?
• You are given the following information about the market for motorcycles.
• Market Demand: P = 400 – 4Q
• Market Supply: P = 4Q
• a. Find the equilibrium price and quantity in this market.
• b. What is the value of consumer surplus in this market?
• c. What is the value of producer surplus in this market?
• d. Suppose that the government decides to impose an excise tax of $80 per
motorcycle on producers in this market. What will be the number of motorcycles
sold in this market once this tax is imposed?
• e. Given the tax described in part (d), what will be the tax incidence on
consumers?
• f. Given the tax described in part (d), what is the value of the deadweight loss from
the tax?
• g. What is the loss in producer surplus from the imposition of the excise tax
described in part (d)?
• h. Suppose the government would like motorcycle consumption to fall to 20 units.
Relative to the initial situation before there was any excise tax, how big an excise
tax would the government need to place on motorcycles in order for consumption
to fall to 20 units?