Ch 8: Application: The Costs of TaxationMonday, October 6, 201410:44 PM -"Taxes are what we pay for civilized society" - Oliver Wendell Holmes Jr. -A tax raises the price buyers pay and lowers the price sellers receive-The cost of taxes to buyers and sellers exceeds the revenue raised by the governmentThe Deadweight Loss of Taxation-The outcome is the same whether a tax on a good is levied on buyers or sellers of the goodoWhen a tax is levied on buyers, demand curve shifts down by the size of the taxoWhen a tax is levied on sellers, supply curve shifts up by that amount-Tax on a good places a wedge between the price buyers pay and the price sellers receive. The quantity of the good sold falls. -How Tax Affects Market ParticipantsoThe benefit receive by buyers is measured by consumer surplus and the benefit received by sellers is measured by producer surplusSupplySize of tax (T)-The tax revenue that the government collects equals T*Q, the area of the rectangle b/w the supply and demand curves Price buyers PayTax Revenue (T*Q)' :Price Sellers Receive Quantity sold (Q)DemandQuantity w/ taxQuantity w/o tax Without Tax With Tax ChangeConsumer Surplus A + B + C A -(B+C)Producer Surplus D + E + F F -(D+E)Tax Revenue None B + D +(B+D)Total Surplus A + B + C + D + E + F A + B + D + F -(C+E)SupplyPrice buyers pay w/ taxAB D F CPrice w/o tax Price sellers receive w/ taxEA tax on a good reduces the consumer surplus (by the area B+C) and producer surplus (by the area D+E). Because the fall in producer and consumer surplus exceeds tax revenue (area B+D), the tax is said to impose a deadweight loss (area C+E).DemandQ2Q1 -The tax makes buyers and sellers worse off and the government better off. -The losses to buyers ands sellers from a tax exceed the revenue raised by the government-Deadweight loss: the fall in total surplus that results from a market distortion, such as tax (C+E)-Because taxes distort incentives, they cause markets to allocate resources inefficiently-Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade-A tax causes the marginal buyers and sellers to leave the market so the quantity sold decreasesThe Determinants of the Deadweight Loss-A tax has a deadweight loss because it induces buyers and sellers to change their behavior-Tax raises the price buyers pay, so they consume less. Tax lowers the price received by sellers, so they produce less-The elasticities of supply and demand measure how much sellers and buyers respond to the changes in the price and, therefore, determine how much the tax distorts the market outcome-The greater the elasticities of supply and demand, the greater the deadweight loss of the tax The Deadweight Loss Debate-The larger the deadweight loss of taxation, the larger the cost of any government program -If the deadweight loss is large, then the losses are a strong argument for a government that doesless and taxes less-If the deadweight loss is small, then government programs are less costly -A labor tax places a wedge between the wage that firms pay and the wage the workers receive. For a typical worker, the marginal tax rate on labor income is about 40%-Economists who argue that labor taxes do not greatly distort market outcomes believe that laborsupply is fairly inelasticoThey claim that most people would work full time regardless of the wage-Economists who argue that labor taxes are highly distorting believe that labor supply is more elastic. They claim that many groups of workers respond more to incentives: oLabor taxes encourage workers to work fewer hours, second earners to stay at home, theelderly to retire early, and the unscrupulous to enter the underground economyDeadweight Loss and Tax Revenue as Taxes Vary Deadweight LossThe Laffer Curve and Supply-Side Economics-In 1974, Arthur Laffer suggested that the United States was on the downward sloping side of the Laffer curve. He said that tax rates were so high that reducing them would actually increase tax revenue but there was little evidence that U.S. tax rates had reached such extreme levels. -The Laffer curve captured the imagination of Ronald Reagan. He argued that taxes were so high that they were discouraging hard work and that lower taxes would give people the proper incentive to work, which would raise economic well-being-Because the cut in taxes was intended to encourage people to increase the quantity of labor supplied, the views of Laffer and Reagan became known as supply-side economics-Economists agree and disagree about these issues because there is no consensus about the size of the relevant elasticities. -How much revenue government gains or loses from a tax cannot be computed just by looking at tax rates. It also depends on how the tax change affects people's behaviorConclusions-When government imposes taxes on buyers or sellers of a good, society loses some of the benefits of market efficiency -Taxes are costly to market participants not only because taxes transfer resources from those participants to the government but also because they alter incentives and distort market outcomes. -Microeconomists study how best to design a tax system, including how to strike the right balance between equality and efficiency-Macroeconomists study how taxes influence the overall economy and how policymakers can use the taxsystem to stabilize economic activity and to achieve more rapid economic growth. Tax RevenueTax revenue first rises with the size of the tax, but as the tax gets larger, the market shrinks so much that the tax revenue starts to fall. As the size of a tax increases, its deadweight loss quickly gets largerLaffer curveTax SizeTax