Application The Costs of Taxation 10 23 2012 Since these effects are the same whether the tax is imposed on the buyers or on the sellers our analysis will be simplified by o Not distinguishing between these two types of tax o Not showing a shift of a demand curve or supply curve in our How does a sales tax affect the economic well being of market graphs participants o Taxes and Efficiency Consumer surplus and taxes to consumers Producer surplus and taxes o A tax on a good tends to increase the price of the good o The loss of consumer surplus measures how harmful the tax is o A tax on a good tends to decrease the amount of money a producer gets from selling the good o The loss of producer surplus measures how harmful the tax is to producers Another effect of a tax o The government that imposed the tax gets revenue o Citizens can potentially benefit from the things on which the tax revenue is spent education roads Total surplus is taken to be the sum of Meausuring gains and losses from a tax on a good o Consumer surplus for buyers o Producer surplus for sellers o Tax revenue for government Tax Revenue o T size of the tax o Q t quantity of good sold o T x Q t Government s tax revenue W o a tax CS a b C PS d e f Tax Revenue 0 Total Surplus CS PS TR A B C D E F How a tax affects welfare o A change in welfare includes changes in o CS A smaller CS o PS F smaller PS o TR B D Positive amount of tax revenue Tax Reduces Total Surplus By C E o Smaller Overall Welfare o Deadweight Loss from a tax the difference between the total surplus without the tax and the sum of consumer surplus producer surplus and government revenue after the tax C E is the deadweight loss of the tax Because of the tax units between Q t and Q e aren t sold The value of these units to buyers is greater than the cost of producing them Tax prevents some mutually beneficial trades Determinants of the size of the deadweight loss o What determines whether the deadweight loss from a tax is large or small The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price That depends on the price elasticities of supply and demand A Per Unit tax on goods with inelastic demand produces a smaller deadweight loss than a per unit tax on goods with elastic demand inelastic demand Because distortion change in q is smaller with Policies o Some policy debates where deadweight loss should be taken into account For some government programs a sales tax is a dedicated revenue source The larger the deadweight loss DWL The larger the cost of the government program When a tax causes a large DWL These losses provide a strong argument for a leaner government program A tax on income can be thought of as a sales tax in a labor market For the workers in the US FICA taxes social security tax medicare tax federal state and local income taxes The marginal tax rate on labor income for a typical worker is currently about 40 Places a wedge between wage that firms pay and wage that workers receive How big should the government be o If labor supply is inelastic then this DWL is small which provides an argument for a relatively large government o Some economists believe labor supply is inelastic arguing that most workers work full time regardless of the wage o Other economists believe that at least some groups of workers have elastic supply because Many workers can adjust their hours 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 Some people work in the underground economy to they earn evade high taxes Effects from changing the Size of the Tax o Policymakers often change taxes raising some and lowering others o What happens to DWL when taxes change T Tax per Unit Doubling the tax causes the DWL to more than double Tripling the tax causes DWL to more than triple 10 25 markets Perfectly competitive markets produce efficient outcomes Government intervention not required to achieve efficiency in these When markets fail to produce an efficient outcome we call the result market failure failing to maximize total surplus o In some markets a decision of one agent will affect the well being of another agent o A steel firm produces steel and pollution Sometimes firms do not bear all of the consequences or reap all of the rewards of their actions If the costs of an agent s decision are not entirely paid by the agent or the benefits of an agent s decision are not entirely reaped by the agent we say an externality exists When does an externality occur o Whenever a person or firm engages in an activity that influences the well being of a bystander and yet neither pays nor receives compensation for that side effect Negative externalities impose costs on others Positive externalities provides benefits to others o Ex a firm that uses pollution abatement equipment o A new invention may generate positive externalities as does an architecturally beautiful home When there is no government intervention in a market a negative externality or positive externality can cause the market to be The benefit from an additional unit of a good or service that the consumer of that good or service receives will be called private inefficient value o The demand curve shoes the private value prices buyers are o Private value is another term for willingness to pay of a The cost of producing an additional unit of a good or service borne by the producer of that good or service will be called private cost o The supply curve shows private cost costs directly incurred willing to pay marginal buyer by sellers seller o Private Cost is another term for the cost borne by a marginal The cost to bystanders affected adversely by a negative externality will be called an external cost o External cost is the cost of the negative impact on bystanders o 1 per gallon monetary value of harm from congestion accidents pollution o Social cost private external cost Evaluating Market Equilibrium Our measure of society s well being will be o consumer surplus producer surplus total external cost o A quantity that maximizes our measure of society s well being will be called a socially optimal quantity or social optimum o The socially optimal quantity is determined by the intersection of the demand curve and the social cost curve o The socially optimal quantity is less than the market o A good with a negative externality Is overproduced by the
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