TAXES taxes Governments levy to raise revenue for public projects How Taxes on Buyers and Sellers Affect Market Outcomes discourages Taxes market activity When a good is taxed the falling quantity sold is share Buyers and sellers the tax burden A Tax on buyers Price of Ice Cream Price Cone buyers pay 3 30 Price 3 00 2 80 without tax Price sellers receive Supply S1 Equilibrium without tax Tax 0 50 A tax on buyers shifts the demand curve downward by the size of the tax 0 50 Equilibrium with tax D1 D2 0 90 100 Quantity of Ice Cream Cones 1 sellers A Tax on Price of Ice Cream Price Cone buyers pay 3 30 3 00 Price 2 80 without S2 Equilibrium with tax S1 Tax 0 50 A tax on sellers shifts the supply curve upward by the amount of the tax 0 50 Equilibrium without tax tax Price sellers receive Demand D1 0 90 100 Quantity of Ice Cream Cones Elasticity and Tax Incidence Tax incidence is the manner in which the burden of a tax is shared among participants in a market Elasticity and Tax Incidence In what proportions is the burden of the tax divided How do the effects of taxes on sellers compare to those levied on buyers The answers to these questions depend on the and the 2 How the Burden of a Tax Is Divided a Elastic supply inelastic demand Price 1 When supply is more elastic than demand Price buyers pay Supply Tax 2 the incidence of the tax falls more heavily on consumers Price without tax Price sellers receive 3 than on producers Demand Quantity 0 How the Burden of a Tax Is Divided Inelastic supply elastic demand b Price 1 When demand is more elastic than supply Price buyers pay Supply Price without tax 3 than on consumers Tax Price sellers receive 2 the incidence of the tax falls more heavily on producers 0 Demand Quantity ELASTICITY AND TAX INCIDENCE So how is the burden of the tax divided The burden of a tax falls more heavily on the side of the market that is less elastic 3 The Costs of Taxation Costs of Taxation is the study of how the allocation of resources affects economic wellbeing Buyers and sellers receive from taking part in the market The equilibrium in a market maximizes the of buyers and sellers THE DEADWEIGHT LOSS OF TAXATION It does not matter whether a tax on a good is levied on buyers or sellers of the good the price rises paid by buyers and the price received by falls sellers The Effects of a Tax Price Supply Price buyers pay Size of tax Price without tax Price sellers receive Demand 0 Quantity with tax Quantity without tax Quantity 4 How a Tax Affects Market Participants A tax places a wedge between the price buyers pay and the price sellers receive Because of this tax wedge the quantity sold below falls the level that would be sold without a tax The size of the market for that good rises How a Tax Affects Market Participants Tax Revenue size of the tax T quantity of the good sold Q T Q the government s tax revenue Tax Revenue Price Supply Price buyers pay Size of tax T Tax revenue T Q Price sellers receive Demand Quantity sold Q 0 Quantity with tax Quantity without tax Quantity 5 How a Tax Effects Welfare Price Price buyers PB pay Supply A B C Price without tax P1 Price sellers PS receive E D F Demand 0 Q2 Q1 Quantity How a Tax Affects Market Participants Changes in Welfare Change in A is the fall in total surplus that welfare results from a market distortion such as a tax How a Tax Affects Welfare 6 How a Tax Affects Market Participants The change in total welfare includes The change in consumer surplus The change in producer surplus and The change in tax revenue The losses to buyers and sellers the revenue raised by the government This fall in total surplus is called the Deadweight Losses and the Gains from Trade deadweight Taxes cause because they prevent buyers and sellers from realizing some of the gains from trade The Deadweight Loss Price Lost gains from trade PB Supply Size of tax Price without tax PS Cost to sellers Value to buyers 0 Q2 Demand Q1 Quantity Reduction in quantity due to the tax 7 DETERMINANTS OF THE DEADWEIGHT LOSS What determines whether the deadweight loss from a tax is large or small The magnitude of the deadweight loss depends on demand how much the and supply respond to changes in the price That in turn depends on the of supply and demand Tax Distortions and Elasticities Inelastic supply a Price Supply When supply is relatively inelastic the deadweight loss of a tax is small Size of tax Demand 0 Quantity Tax Distortions and Elasticities b Elastic supply Price When supply is relatively elastic the deadweight loss of a tax is large Size of tax Supply Demand 0 Quantity 8 Tax Distortions and Elasticities c inelastic demand Price Supply Size of tax When demand is relatively inelastic the deadweight loss of a tax is small Demand Quantity 0 Tax Distortions and Elasticities d elastic demand Price Supply Size of tax Demand When demand is relatively elastic the deadweight loss of a tax is large 0 Quantity DETERMINANTS OF THE DEADWEIGHT LOSS price The the elasticities of demand and supply the will be the decline in equilibrium quantity and the the deadweight loss of a tax 9 DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY The Deadweight Loss Debate Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic Some examples of workers who may respond more to incentives Workers who can adjust the number of hours they work Families with second earners Elderly who can choose when to retire Workers in the underground economy i e those engaging in illegal activity DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY With each in the tax rate the deadweight loss of the tax even more rapidly than the size of the tax Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Small tax a Price Deadweight loss Supply PB Tax revenue PS Demand 0 Q2 Q1 Quantity 10 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes b Medium tax Price Deadweight loss PB Supply Tax revenue PS Demand Q2 0 Q1 Quantity Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes c Large tax Price PB Tax revenue Deadweight loss Supply Demand PS 0 Q2 Q1 Quantity DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY smaller For the small tax tax revenue is As the size of the tax rises tax revenue increases But as the size of the tax continues to rise tax decreases revenue because the higher tax reduces the size of the market 11 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax deadweight loss a Deadweight Loss Tax