Application: The Costs of Taxation

PUBLIC FINANCE LECTURE NOTES

DEADWEIGHT LOSS (DWL)

By Dr. Maganya, M
Department of Economics and Tax
Management

APPLICATION: THE COSTS OF TAXATION 1

In this lecture, 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?

APPLICATION: THE COSTS OF TAXATION 2

 Review from last lecture
 A tax is a wedge between the price buyers pay
and the price sellers receive.
 A tax raises the price buyers pay and lowers the
price sellers receive.
 A tax 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 lecture.

APPLICATION: THE COSTS OF TAXATION 3

 The Effects of a Tax
P
With no tax,
eq’m price is PE
and quantity is QE . Size of tax = $T
Govt imposes a PB S
tax of $T per unit.
PE
The price buyers
pay is PB , PS D
the price sellers
receive is PS ,
and quantity is QT . Q
QT QE

APPLICATION: THE COSTS OF TAXATION 4

 The Effects of a Tax
P
The tax generates
revenue equal to Size of tax = $T
$ T x QT .
PB S

PE

PS D

Q
QT QE

APPLICATION: THE COSTS OF TAXATION 5

 The Effects of a Tax
 Next, we use the tools of welfare economics to
measure the gains and losses from a tax.
 We will determine consumer surplus (CS),
producer surplus (PS), tax revenue, and total
surplus with and without the tax.
 Tax revenue is included in total surplus, because
tax revenue can be used to provide services
such as roads, police, public education, etc.

APPLICATION: THE COSTS OF TAXATION 6

 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

APPLICATION: THE COSTS OF TAXATION 7

 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 causes
total surplus to Q
fall by C + E QT QE

APPLICATION: THE COSTS OF TAXATION 8

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

Q
QT QE

APPLICATION: THE COSTS OF TAXATION 9

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

so the tax has

prevented some
mutually beneficial Q
trades. QT QE

APPLICATION: THE COSTS OF TAXATION 10

A C T I V E L E A R N I N G 1:
The market for
Analysis of tax airplane tickets
P
A. Compute
$ 400
CS, PS, and
total surplus 350
without a tax. 300 S
B. If $100 tax 250
per ticket, 200
compute 150 D
CS, PS,
100
tax revenue,
total surplus, 50
and DWL. 0 Q
0 25
APPLICATION: THE COSTS OF TAXATION 50 75 100 125 11
A C T I V E L E A R N I N G 1:
The market for
Answers to A P airplane tickets
CS $ 400
= ½ x $200 x 100 350
= $10,000 300
S
PS 250
= ½ x $200 x 100 P = 200
= $10,000 150
D
total surplus 100
= $10,000 + $10,000 50
= $20,000 0 Q
0 25 50 75 100 125
APPLICATION: THE COSTS OF TAXATION 12
A C T I V E L E A R N I N G 1:
A $100 tax on
Answers to B P airplane tickets
CS $ 400
= ½ x $150 x 75 350
= $5,625 300
PS = $5,625 S
PB = 250
tax revenue 200
= $100 x 75 PS = 150
= $7,500 D
100
total surplus 50
= $18,750
0 Q
DWL = $1,250 0 25 50 75 100 125
APPLICATION: THE COSTS OF TAXATION 13
What Determines the Size of the DWL?
 The govt needs tax revenue to finance roads,
schools, police, etc., so it must tax some goods
and services.
 Which ones? One answer is that govt should tax
the goods or services with the smallest DWL.
 So when is the DWL small vs. large? Turns out it
depends on the elasticities of supply and demand.

 Recall: The price elasticity of demand (or supply)

measures how much quantity demanded
(or supplied) changes when the price changes.
APPLICATION: THE COSTS OF TAXATION 14
 DWL and the Elasticity of Supply

When supply
P
is inelastic,
the DWL of a S
tax is small.

Size
of tax

D
Q

APPLICATION: THE COSTS OF TAXATION 15

 DWL and the Elasticity of Supply

S
The more elastic
is supply, Size
the larger is of tax
the DWL.
D
Q

APPLICATION: THE COSTS OF TAXATION 16

 DWL and the Elasticity of Supply

When demand
P
is inelastic,
the DWL of a S
tax is small.
Size
of tax

D
Q

APPLICATION: THE COSTS OF TAXATION 17

 DWL and the Elasticity of Supply

The more elastic

is demand, Size
of tax
the larger is
D
the DWL.

APPLICATION: THE COSTS OF TAXATION 18

 Why Elasticity Affects the Size of DWL
 A tax distorts the market outcome:
consumers buy less and producers sell less,
so equilibrium Q is below the surplus-maximizing
quantity.
 Elasticity measures how much buyers and
sellers respond to changes in price,
and therefore determines how much the
tax distorts the market outcome.

APPLICATION: THE COSTS OF TAXATION 19

 How Big Should the Government Be?
 A bigger government provides more services,
but requires higher taxes, which cause DWL.
 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.
 How big is the DWL from this tax?
It depends on elasticity….

APPLICATION: THE COSTS OF TAXATION 20

 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 21

 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 22

 Suppose the market for cameras has a supply
curve of P = 30 + Q, and a demand curve of P
 = 240 – 2Q. Assume that the market is perfectly
competitive.
 a) What will the equilibrium price and quantity of
cameras be?
 b) Calculate the producer and consumer surplus
associated with the equilibrium found in
 part (a). Illustrate on a graph.

APPLICATION: THE COSTS OF TAXATION 23

 c) Suppose the government levies a tax of $18
per camera sold. What is the new quantity
 of cameras sold? What price do consumers
pay? What price do producers receive?
 Illustrate on a graph.
 d) Find the new producer and consumer surplus
associated with your answer to part (c).
 e) How much revenue does the government
raise from the tax?
 f) How does the sum of consumer surplus,
producer surplus, and revenue after the tax
APPLICATION: THE COSTS OF TAXATION 24
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 25

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

Q
Q2 Q1

APPLICATION: THE COSTS OF TAXATION 26

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

Tripling the tax S

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

Q
Q3 Q1

APPLICATION: THE COSTS OF TAXATION 27

 DWL and the Size of the Tax
Implication Summary
When tax rates are When a tax increases,
low, raising them DWL rises even more.
doesn’t cause much DWL
harm, and lowering
them doesn’t bring
much benefit.
When tax rates are
high, raising them is
very harmful, and
cutting them is very
beneficial. Tax size

APPLICATION: THE COSTS OF TAXATION 28

 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 29

 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 30

 The Laffer curves shown here and in the book are
symmetric, and their peak occurs in the middle. This
need not be the case, and probably is not the case.
However, we just don’t know where the peak is – it
could be at a tax rate of 20% or a tax rate of 200% -
and surely varies across goods.
 The textbook has some excellent discussion of the
Laffer curve, President Reagan, and supply-side
economics, which you should encourage your
students to read.

APPLICATION: THE COSTS OF TAXATION 31

LECTURE 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.

APPLICATION: THE COSTS OF TAXATION 32

LECTURE 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.

APPLICATION: THE COSTS OF TAXATION 33

 Thank You For
Your Attention!!!

APPLICATION: THE COSTS OF TAXATION 34