Chapter 8 Application The Costs of Taxation The Deadweight Loss of Taxation Taxes cause the size of the market to shrink A tax on a good places a wedge between the price that buyers pay and the price that sellers receive quantity of the good sold falls The tax revenue that the government collects equals T Q T size of the tax Q quantity sold tax revenue equals the area of the rectangle between the supply and demand curves A tax on a good reduces consumer surplus and producer surplus b c the fall in producer and consumer surplus exceeds tax revenue the tax is said to impose a deadweight loss Deadweight loss the fall in total surplus that results when a tax distorts a market outcome taxes distort incentives cause markets to allocate resources inefficiently Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade The Determinants of the Deadweight Loss Price elasticities of supply demand determine whether the deadweight loss from a tax is large or small Tax raises price paid by buyers so they consume less tax lowers the price received by sellers so they produce less size of market shrinks below optimum The greater the elasticities of supply demand the greater the deadweight loss of a tax revenue Deadweight Loss and Tax Revenue as Taxes Vary A small tax has a small deadweight loss and raises a small amount of revenue A somewhat larger tax has a larger deadweight loss and raises a larger amount of A very large tax has a very large deadweight loss but b c it has reduced the size of the market so much the tax raises only a small amount of revenue As the size of a tax grows larger the deadweight loss grows larger however tax revenue first rises and then falls Laffer curve Supply side economics Reagan s view cut in taxes intended to encourage ppl to increase the quantity of labor supplied
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