Chapter 9

THE TAX SYSTEM AND

THE COSTS OF TAXATION

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION 9781473725331 © CENGAGE EMEA 2017
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
 Let’s Remember:
• A tax reduces the quantity bought & sold.
• A tax raises the price buyers pay and lowers the price
sellers receive.
• A tax is a wedge between the price buyers pay and the
price sellers receive.
• These effects are the same whether the tax is imposed
on buyers or sellers, so we do not make this distinction
in this chapter.
 Taxes and Efficiency
•A tax system is designed with two objectives:
Efficiency and equity
•Efficiency: One tax system is more efficient than
another if it raises the same amount of revenue at
a smaller cost to taxpayers and the government
• Costs of Taxation
• Deadweight Loss
• Administrative Costs
 Effects of a Tax
Price

Supply

Price buyers Size of tax

pay

Price
without tax

Price sellers
receive

Demand

0 Quantity Quantity Quantity

with tax without tax
 Effects of a Tax

•Government’s Tax Revenue:

• T : Size of the Tax
• Q: Quantity of the Good Sold

Tax Revenue : T x Q
 Tax Revenue
Price

Supply

Price buyers Size of tax (T)

pay
Tax
revenue
(T × Q)

Price sellers
receive

Quantity Demand
sold (Q)

0 Quantity Quantity Quantity

with tax without tax
 The Effects of a Tax
• 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.
 How a Tax Effects Welfare
Price Deadweight
Loss
A Supply
Price
buyers = PB
pay
B
Price C
without tax = P1
E
Price D
sellers = PS
receive F

Demand

0 Q2 Q1 Quantity
How a Tax Affects Market Participants
 About the Deadweight Loss (DWL)
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 of producing PS D
them, so the tax has
prevented some mutually
beneficial trades.
Q
QT QE
 What Determines the size of DWL?
•Efficiency objective:
• The Government should tax the goods and services
with the smallest DWL.
•Size of the deadweight loss depends on how much the
quantity supplied and quantity demanded respond to
changes in the price.
•That means, DWL depends on the price elasticities of
supply and demand.
Tax Distortions and Price Elasticities
Case a. Price Inelastic Supply
Price

Supply

When supply is
relatively price inelastic,
the deadweight loss
of a tax is small.
Size of tax

Demand

0 Quantity
Tax Distortions and Price Elasticities
Case b. Price Elastic Supply
Price

When supply is relatively

price elastic, the deadweight
loss of a tax is large.

Size Supply
of
tax

Demand

0 Quantity
Tax Distortions and Price Elasticities
Case c. Price Inelastic Demand
Price

Supply

Size of tax
When demand is
relatively price inelastic,
the deadweight loss
of a tax is small.

Demand

0 Quantity
Tax Distortions and Price Elasticities
Case d. Price Elastic Demand
Price

Supply

Size
of
tax Demand

When demand is relatively

price elastic, the deadweight
loss of a tax is large.

0 Quantity
 Price Elasticity and DWL
•The greater the price elasticities of demand or
supply:
• The larger will be the decline in equilibrium quantity
• The larger will be the deadweight loss of a tax
 DWL, Tax Revenue and Tax Rates

• With each increase in the tax rate, the deadweight

loss of the tax rises even more rapidly than the
size of the tax.
• Let’s see with three different tax rates
DWL and Tax Revenue with Different Tax Rates

Price

Deadweight
loss Supply
(a) Small Tax PB
Tax revenue
PS

Demand

0 Q2 Q1 Quantity
DWL and Tax Revenue with Different Tax Rates
Price

Deadweight
PB loss
Supply
(b) Medium Tax
Tax revenue

PS Demand

0 Q2 Q1 Quantity
DWL and Tax Revenue with Different Tax Rates
Price
PB
Deadweight
loss
Supply

Tax revenue
(c) Large Tax

Demand

PS
0 Q2 Q1 Quantity
DWL and Tax Revenue with Different Tax Rates

• As taxes increase, so does the deadweight loss

from the tax.
• For the small tax, tax revenue is small.
• As the size of the tax rises, tax revenue grows.
• But as the size of the tax continues to rise, tax
revenue falls because the higher tax reduces the
size of the market.
How Tax Revenue Responds to the Size of a Tax

Tax
Revenue As the tax size
increases, the
tax revenue will
increase at
The Laffer curve first, but will
eventually fall.

0 Tax Size
 Administrative Burden

• Complying with tax laws creates additional costs:

• Taxpayers spend time and money documenting,
computing, and filling tax forms.
• These are additional administrative costs they incur,
over and above the actual taxes they pay.
• The administrative burden of any tax system is part of
the inefficiency it creates.
 Design Of The Tax System

• Adam Smith’s Four Canons Of Taxation:

1. Equality: Each person should pay taxes according to
their ability to pay: the rich pay more
2. Certainty: Tax payers need to know what taxes they
owe and be able to plan ahead
3. Convenience: Paying taxes should be made as easy
as possible
4. Economic: Cost of collecting and administering
taxes must be less than the amount collected
 Equity

Different tax system with respect to equity:

• A proportional tax is one for which high-income and
low-income taxpayers pay the same fraction of income.
• A regressive tax is one for which high-income
taxpayers pay a smaller fraction of their income than
do low-income taxpayers.
• A progressive tax is one for which high-income
taxpayers pay a larger fraction of their income than do
low-income taxpayers.
Three Tax Systems
 Turkey : Income Tax Brackets for 2020

Income from TRY.. To TRY ….. Tax on lower brackets Tax Rate on Excess (%)

0 22.000 - 15

22.000 49.000 3.300 20

49.000 180.000 8.700 27

180.000 600.000 44.070 35

600.000 And above 191.070 40